Have You Outgrown the Person You Used to Be?
Second Level Thinking · Issue 13
Why your ego is the primary enemy of progress and how to audit your beliefs. A masterclass in R-multiples: the only metric that truly matters for your trading system.
Ego Is the Enemy
The path of ambition can be dangerous and one must ask, “if your belief in yourself is not dependent on actual achievement, then what is it dependent on? The answer, too often when we are setting out, is nothing. Ego. And this is why we so often see precipitous rises followed by calamitous falls,” writes Ryan Holiday in Ego Is The Enemy.
As a result, Isocrates’ warning to Demonicus around the year 374 B.C., still rings true. A well known teacher in Athens at the time, Isocrates wrote to his ambitious student: “no adornment so becomes you as modesty, justice and self-control; for these are virtues by which all are agreed.” Practice self-control and don’t fall sway to “temper, pleasure and pain. The pride of the arrogant, even slaves can hardly endure.” Constantly train your intellect, he told him, “for the greatest thing in the smallest compass is a sound mind in a human body.”
Ego, Ryan defines as “an unhealthy belief in our own importance. Arrogance. Self-centred ambition. It’s the petulant child inside every person, the one that chooses getting his or her way over anything or anyone else. The need to be better than, more than, recognised for, far past any reasonable utility - that’s ego. It’s the sense of superiority and certainty that exceeds the bounds of confidence and talent.”
Essentially, it limits our ability to achieve. We cannot improve what we don’t understand - how can we give or receive feedback if we are incapable or uninterested in hearing from outside sources. How can we recognise opportunities, or create them if stuck inside our own fantasy. How are we supposed to reach, motivate, or lead other people if we cannot relate to their needs, because we have lost touch with our own.
Facts are better than dreams, as Churchill put it. Although many share a vision for greatness, we must understand our path toward achieving it is very different from one another. We learn that in thinking big, we must keep our daily actions small in order to accomplish. And as a result of this bias to action and ongoing education, we forgo validation and status, rooting ourselves in a much healthier state.
In choosing an alternative we negate the ego before unhelpful habits form, replace the temptation of ego with humility and discipline when we taste the fruits of success, and cultivate strength and fortitude so we are not destroyed by failure. In short, Ryan summarises this as:
Be humble in our aspirations.
Be gracious in our success.
Be resilient in our failures.
In today’s society it is easy for talk and hype to replace action; that empty text box, the company group chat, the iMessage, the email, the Facebook prompt “what’s on your mind?” All these blank spaces begging to be filled in with what we are going to do, or what we should do, or what we hope will happen. But, almost exclusively, it is positive in nature and rarely is it what we are scared, or uncertain of. Although, in most instances there is no malice in seeking comfort externally, there is an element of wanting as much public credit and attention for doing the least, that is the ego.
We have all been geared toward thinking that silence is a sign of weakness, so we talk, talk, and talk as though our life depends on it. But talk depletes us and in silence there is strength. Research shows that while goal visualisation is important, after a certain point our mind begins to confuse it with actual progress. The same goes for verbalisations, even talking aloud to ourselves whilst problem solving can significantly limit insight and breakthroughs. So in short, let your action speak louder than your words.
Epictetus says: “you cannot learn if you think you already know.” We must become our own teachers, tutors and critics. It would be far better if you were intimidated by what lies ahead - humbled by its magnitude and determined to see it through regardless. To stay humble and when starting out we must remember a few fundamental realities:
You’re not nearly as good or as important as you think you are.
You have an attitude that needs to be readjusted.
Most of what you think you know is out of date or wrong.
In a professional setting we are told to build our “personal brand” and are continually required to sell our work, our talents and develop our networks. Anyone with a sniff of ambition can fall prey to being swept up by the self-created narrative in our heads. Hey, it feels good and certainly feels better than feelings of doubt and fear. As John D. Rockefeller later reflected on his own shortcomings: “I had a horror of the danger of arrogance. What a pitiful thing it is when a man lets a little temporary success spoil him, warp his judgement, and he forgets who he is!”
Henry Ford preferred to state “you can’t build a reputation on what you’re going to do.” And in adopting the principle of “say little, do much” we are able to become lesser but in doing so achieve much more. Think the next time you are faced with a choice: do I need this? Or is this really about ego? To be or to do - life is a constant roll call. No matter what you’ve done up to this point, remain the student. If you’re not still learning, you’re already dying.
Only you know the race you’re running. That is, unless your ego decides the only way you have value is if you’re better than, have more than, everyone, everywhere. According to Seneca, the Greek word euthymia is one we should think of often. It is the sense of our own path and how to stay on it without getting distracted by all the others that intersect it. Be what you are and be as good as possible - do your work. Do it well and then let it go. Recognition and rewards, those are just extra. And as John Wooden used to tell his players: “success is peace of mind, which is a direct result of self-satisfaction in knowing you made the effort to do your best to become the best that you are capable of.”
R and R-Multiples
How many times have you heard the phrase “cut your losses and ride your winners” in financial markets? Well if words to that effect are one of the golden rules of trading then position sizing controls how much equity you risk on any given trade. So what are R and R-multiples and how can you effectively apply position sizing strategies to reach your objectives? To answer this, today is a share from the late, great, Van Tharp and his work on the topic.
R stands for the risk you take on any trade when you enter the market. Risk is the amount that you are willing to lose on the trade in order to achieve a profit. In terms of price, R is the point at which you plan to get out of your position in order to preserve your capital. For example, if you buy a stock at $50 and you plan to get out if it drops to $47 or below, then your R-value per share in this trade is $3.00 (i.e., $50 - $47 = $3.00). If you buy 100 shares of stock your total risk for the trade is $300, which is your total 1R value.
Your R-multiple is simply the amount that you profited or lost in terms of your initial risk. If you purchased that stock at $50 with the initial stop price of $47 and exited at $47, then you have a -1R trade. You lost what you risked - $3. If, however, the stock went up and you exited at $56, then you had a +2R trade because you earned twice what you risked ($56 - $50 = $6, $6 ÷ $3 = 2).
You want your losses to have an R-multiple between 0 and -1. Losses can be bigger than -1R when the market gaps against you and goes through your “get me out” price. They can also be bigger than -1R when you make psychological mistakes and fail to get out at your stop point. Excessive costs (commissions and slippage) can also result in larger negative R-multiples.
Now suppose you have a trading system where you make +5R on the winning trades. When your trades lose, however, you lose only -1R. If your system is right one time (+5R) for every three losses (3 × -1R = -3R), then the system averages a 2R gain (+5R - 3R = +2R) over four trades. If we continue with this example and risk $3 for each share, then over four trades we would expect to see $9 in losses and $15 in gains for a net profit of $6 per share ($6 per share = $3 per share × 2R). Imagine that! You are right 25% of the time and you still make money. (If you were to risk 1% of your equity on each trade, this system would generate about a 2% gain in your equity every four trades.)
The principle of cutting your losses short (so you will have small R-multiple losses) and letting your profits run (so you will have big R-multiple gains) is critical for profitable trading.
Expectancy versus Probability
Expectancy is a mathematical formula that tells you how much you will win on the average per dollar risked. It takes into account both the probability of winning (or losing) and the size of the R-multiples. Casino gambling games are all negative expectancy games; you cannot make money in the long run unless you can do something to change the odds. In trading, you must play a different game from gambling. You must have a positive expectancy game on your side in order to make money in the long run. Expectancy is actually the average R-multiple that your system will give you per trade.
Most people look for trading systems that make them right. That is a mistake. Such games can have a negative expectancy (meaning that you'll lose money overall) if some of the losers have large R-multiples. More importantly, some of the best trading ideas have large R-multiples in your favour, but only make money 25-40% of the time.
Let's look at an example: suppose you buy a stock at $50 and plan to get out when it drops against you by a dollar to $49. However, when you are right you expect that stock to move 30%. In this case, a 30% move is an additional $15. When a trade fails, you lose one dollar per share. When a trade works, you make 15R or $15 per share! What if you were only right 30% of the time and you make money in three of ten trades? In ten trades you'd make $15 per share an average of three times. Your total gain would be $45 per share. In the same ten trades, you'd lose $1 per share on the average seven times. Your total loss would be $7 per share. Over the ten trades you'd end up making $38 per share (or 38R), even though you were only right 30% of the time. Large R-multiples in your favour are much more significant than ‘being right’ for making money in the market. Remember that! And if you had risked 1% of your total equity on this system, you would have been up about 38% at the end of 10 trades.
Even though more trades lose than win in that example, the large size of the winning trades outweigh the losses so the system has a positive expectancy. To calculate expectancy, determine the average R-multiple for the system, taking into account both the positive and negative Rs. The mean R is the system’s expectancy.
There is a critical aspect to expectancy that you must understand. Expectancy and probability are not necessarily the same. As we mentioned earlier, you must have expectancy on your side, but you don't need to have probability on your side. Let's look at the example given earlier. You win 30% of the time, and when you win it's a 15R gain. You lose 70% of the time, and when you lose it's a 1R loss. You only make money 30% of the time. Thus, the odds are against you. However, the game has a positive expectancy, giving you an average of 3.8 times your risk each trade or 3.8R.
Using Position Sizing
There is a percentage of your equity that will give you an optimum return. That optimum percentage will give you the maximum rate of return over time. It will also give terrible drawdowns. Lower percentages of risk will give you less return and smaller drawdowns. Lower percentages could actually increase your chances of meeting your objectives. But if you risk too much, you risk bankruptcy.
One of the main lessons you must master in order to profit in financial markets will be the art of position sizing (I will keep the psychological impacts for another day). Van defines a low risk idea as: “an idea with a positive expectancy that is traded at a risk level that will allow you to survive in the short term, so that you can achieve the positive expectancy over the long term.”
Think about your current and previous trades:
Do your positions form part of a broader system or strategy, or are you simply guessing and trying to be right when placing trades in the market?
Do you have stop losses in place, or have you identified your maximum risk per trade, or are your positions vulnerable to wiping out your entire allocation?
More broadly, are you engaging with the markets in a structured, professional way, or do you simply have hope as a strategy?
Finally, how can you integrate the use of R and R-multiples and develop a position sizing strategy that fits your objectives? A critical task for all traders.
Parting Shot
Have you outgrown your systems or beliefs? Is it time that you upgraded? Or, on a personal level, as Jerry Colonna, executive coach to some of the biggest tech leaders in Silicon Valley would ask: “how are you complicit in creating the conditions you say you don’t want?”
