Friday, March 5, 2010

Pulling the plug

An early epigraph in Dean Shepherd’s book From Lemons to Lemonade: Squeeze Every Last Drop of Success Out of Your Mistakes (Wharton School Publishing, 2009) comes from Bill Gates: “Success is a lousy teacher. It seduces smart people into thinking they can’t lose.” On the other hand, as I wrote in an earlier post, “Success breeds success; with failure it’s just try, try again,” it can be very difficult to learn from our failures.

The first, sometimes seemingly insurmountable problem, is admitting failure and pulling the plug on a project, a trading system, or an individual trade gone wrong. We have been steeped in “Vince Lombardi-style slogans . . . that winners never quit. That quitters never win. That, in the oft-quoted line from the movie Apollo 13, ‘Failure is not an option.’” (p. 53) We are taught that persistence and determination are laudable personal qualities, that we should never give up.

So what are we inclined to do when things are going against us? We may procrastinate, avoiding the negative emotional reaction to pulling the plug. Perhaps things will turn around and we won’t have to take the loss, admit we were wrong, and feel bad.

If we believe that success is within our control, we may try to throw more resources at the problem. “Normally, when you are doing good business, you try and hit singles and doubles, but now that things aren’t working, you are trying to hit triples and home runs. And then you are really in bad trouble.” (pp. 54-55) Nick Leeson is the poster child for making a very bad situation disastrous by scaling up. Placing an unlimited risk short straddle in the Singapore and Tokyo exchanges the day before the Kobe earthquake was a desperate and of course failed attempt to hit a home run. (By the way, if you ever doubt the wisdom of pulling the plug watch Rogue Trader.)

It’s easy to argue that taking a loss on a trade is not failure but simply the cost of doing business. It is equally easy to point out that we aren’t trading our egos; we aren’t failures simply because we bail on a trade or a series of trades. But the fact remains that it takes emotional work to replace the voice of Vince Lombardi with that of the risk manager, especially when we are our own risk managers.

In trading organizations there are usually risk management procedures in place to constrain individual traders. For instance, SAC Capital has “down-and-out” clauses for its portfolio managers. After a 5% drawdown SAC can cut the manager’s trading account in half; after a 10% drawdown, it might be sayonara for the manager. (See the recent Bloomberg article link.

Individual traders need to have well-defined procedures in place for dealing with the inevitable failures, whether they take the form of stop losses, quitting for the day after x number of failed trades, quitting for a period of time after an x% drawdown, or reducing position size. (And this list is certainly not exhaustive.) Making risk management discretionary is courting disaster.

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