When BTFD Goes Bad

It was early 2008. The iPhone had just come out and Netflix was a service that let you temporarily borrow movies on a plastic disk, delivered by a human being.

And you actually had to return them!

The horror.

In one of the more active chat rooms I frequented at the time, I came across an interesting character that went by the name of “Trader1”.

Despite having the most unoriginal screen name in history, he seemed like a nice guy and was always chatting about the market, and the trades he was making.

His trading method was simple – buy the fucking dip.

And he announced his buys with great bravado, calling out, “I’m buying more XYZ on this dip”, or “this dip is a great place to buy more XYZ.”

He bought a lot of stocks on the dip, like CFC, LEH, and BSC. Don’t try to look these stocks up because they don’t exist anymore.

Trader1 eventually disappeared from the chat room and I suspect that the call out he makes most now is, “would you like fries with that?”

The reason Trader1 didn’t succeed was that he thought he was good instead of lucky.

He thought BTFD was a sound method, based on his previous success, but he made a crucial mistake – he used outcome bias to validate his method.

Now that your eyes are rolling back in your head, let me explain what I mean.

Let’s say you go to Las Vegas and you and your buddies go out and get shitty-drunk.

Maybe you drink one of those margaritas in a giant plastic Eiffel Tower, or maybe you split a brewzooka - the delivery vehicle doesn’t really matter.

Now that you’re fully lit, you take everything you own – your car, your house, your life savings, your autographed picture of Patrick Swayze from Roadhouse –everything, and put it on red on the roulette wheel.

Even if red hits, it was a terrible bet, because, although you won, the method you used – everything on red – was flawed.

Eventually, this method will fail – actually, a little more than 50% of the time due to the green “0” – and when it does, the downside is so big that you’ll be wiped out and no longer be able to play the game.

Trader1 fooled himself into thinking that his method worked because in the two years that he had been trading the market rebounded after every dip.

BTFD.

But Trader1’s method did not have any contingency if the market didn’t rebound.

It was based on a consistent one-sided outcome, something that never happens in the real world, and certainly not in the stock market – at least not forever.

The most obvious way Trader1 could have improved his methodology would have been to incorporate a stop-loss rule. In addition, he could have had a target rule, one that would take some, or all, of his profits when a position hit a certain level.

Or he could have decided to take profits beyond a certain amount off the table and into more conservative and stable assets.

But perhaps the best way he could have improved his trading was to create a rules-based methodology – one that is less susceptible to luck.

If his trading was not initially profitable, he could refine his rules until he found a consistently profitable method and then re-evaluate the success of his trading – not based on outcome – but on adherence to his trading rules.

For more about flawed methodologies and fooling yourself into thinking you’re good and not lucky, check out Fooled by Randomness and The Black Swan by Nassim Taleb.

———————————

If you arrived here by accident, happenstance, or magic, make sure you sign up for my free, no obligation, 14-day free trial to The Lund Loop by clicking the button below.

P.S. It should go without saying - but I’ll say it anyway - all opinions expressed in The Lund Loop are my own personal opinions and don’t reflect the views of my employer, any associated entities, or other organizations I’m associated with.

Nothing written, expressed, or implied here should be looked at as investment advice or an admonition to buy, sell, or trade any security or financial instrument. As always, do your own diligence.