Dr. Van Tharp is known for breaking down the trading process into three categories that affect traders. He categorizes them by importance as follows:
- Trading strategy (10%)
- Money management (30%)
- Psychology (60%)
According to Dr. Tharp, the psychological outlook and an individual’s way of thinking towards trading is the most important factor for success. The fact that the actual trading strategy is ranked the least important by Dr. Tharp, suggests that regardless of how successful a strategy is, psychology is the key to being successful.
The main reasons for the poor performance of individual investors are:
- Human Psychology: Individuals make decisions everyday with their emotions assisting their judgment.
- Performance chasing: Investors who chase performance are highly likely to lose money over the long term.
- Casino Investing: Many people think they can make money by winning the lottery.
- The “me too” lemming investment strategy: This is a common strategy of people who don’t know what they are doing with their investments.
- Fear and Greed Investing: Those are the most powerful motivations for investors. Unfortunately, investors tend to alternate between these potentially destructive emotions.
Dr. Tharp indicates three rules for successful trading:
- The first new rule is that trading is as much a profession as any other. It takes significant time (several years) and a deep commitment to become a successful trader.
- The second new rule is that trading reflects human performance just as much as any top athletic endeavor. You must understand that you are responsible for the results you get. Thus, you should devote significant time to working on yourself in order to be successful.
- The third new rule is that objectives are important. Furthermore, you achieve your objectives through position sizing strategies. The quality of your system just tells you how easy it will be to use position sizing strategies to achieve your objectives. Most people don’t even think about objectives, except that they’d like to make a lot of money and avoid losing, and they don’t have a clue about position sizing strategies. They learn that asset allocation is important, but they never understand that what makes it so important is the “how much” factor, which is what position sizing strategies are all about.
On a practical side, there are few tips I can give novice traders to improve their odds:
- Diversify. That doesn’t mean buying 30 stocks instead of 5. That means implementing a mix of non-correlated strategies. No strategy will perform well under all market conditions.
- Find a strategy that you like and stick to it, for at least 6-12 months.
- Find a good trading community that can help you with your trading.
- Have a good plan.
- Set your performance goals in years, not months or weeks.
- When starting trading a new strategy, paper trade for at least one month, then start small and gradually increase the allocation.
- Find a mentor that you can trust and follow him. Try to understand what he is doing. If you don’t understand the rationale and the risks of the trade, don’t take it.