The Psychology of the TopChop - Part 3 of 3

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This is Part 3 in the Series - if you have not read the first 2 parts, I recommend you go right to the bottom of this Blog and you will find links to them - read those first or it probably won’t make a whole load of sense (ok, I will concede that it might not make much sense even after that !!)

The Psychology behind the TopChop
I am much more qualified to speak informatively about this bit because I am very much a proponent of TopChopping and I even demonstrated the technique recently when I sliced off about a third of my BooHoo BOO Exposure after a quite remarkable run up in recent weeks and I also TopChopped my Trifast TRI Position:

• Less Frustration and Mental Angst - this arises because of the ‘Halfway House’ nature of TopChops - you achieve 3 Psychologically pleasing actions at the same time - firstly you ‘Bank some Profits’ which always makes you feel happy, secondly you are ‘still in the Game’ if the Stock continues to rise after your Slice (so your timing doesn‘t need to be 100% exact - which is of course impossible for most Humans anyway) and thirdly you ‘Lower your Downside Risk’ (both for the Individual Position and for your Portfolio). If using Spreadbets, as I was on both my BOO and TRI Positions, you also get the rather nice benefit of reducing your Leverage. With my Psychological make-up, once a Stock has run up a long way and is starting to look very fully valued, I start to think more and more about whether or not I need to get selling it. The discipline of regularly setting and resetting Targets helps to allay this angst, but it gets to the point where I am almost constantly obsessing about it and I find that really unhealthy and irritating. The great thing about doing the Targets is that simply by taking the Action of changing a Target Price makes me feel like I have done something about the situation - however, as it keeps rising I then get to the point where the only Action that will really make me calm down is to do a TopChop and then I feel much more relaxed and happy. Weird innit? I suspect many many Readers will identify with my thoughts here and I suspect there are a large number who sell out of a position way too early simply because this kind of Mental Torture (Waterboarding?) really gets to them (please see my Blogs on ‘Target Setting’ - there is a link at the bottom of this Blog).
• Loss Aversion - Usually in Textbook terms this is to do with our inability to Cut Losses and a tendency to hold onto Losing Positions - this is something I am hugely guilty of. In the context of this Blog, it certainly seems the case for myself that I am overly Risk Averse and I probably take on far less Risk than almost any Investor I know. The downside of this Loss Aversion is that it has definitely hurt my Returns this year because I have been overly Cautious - although of course maybe it is Hindsight Bias and Outcome Bias making me think this way !! Had Markets been very different and not rallied so strongly after the Brexit Vote, then my Hedging would have resulted in a very different Performance for my Portfolio. Please see my recent Blog ‘The Price of Caution’ - there is a Link at the bottom of this Blog - which explores this in more depth. With regards to TopChopping, maybe I tend to Chop too early and maybe I am just simply plain wrong and I would be better off just letting my Individual Winners grow to the Sky !! It is worth considering that the kind of Loss Aversion I suffer from is perhaps partly due to my Lifestyle in that because I am retired I have little alternative Income and it is vital that I protect my Capital above all other considerations - and this means I am psychologically induced to take a lower Risk approach than many other Investors who have Full Time Jobs and perhaps many years of earning ahead of them - in effect they are using their ‘Human Capital’ to enable them to take on more Risk. This year it has certainly been the case that people who are in a position to take Higher Risk have been rewarded - although of course 2016 is not over yet and there is plenty of time for things to rapidly change.

A Related Trading Maxim
All of this is very similar to another Subject area that comes up a lot on Twitter etc. This is the idea that we should “Back our Best Ideas with heavy conviction”. For me this is another one of those ‘Guru’ sayings that probably has limited usefulness in the Real World. The way I consider this is that if you asked me, “which of your Stocks do you think are your Best Picks?”, I might be able to come up with perhaps 5 Stocks or so but I would suspect that if we monitored the performance of those Stocks over the next year or so, we would find that probably none of them were great performers and it would be 5 completely different Stocks within my Portfolio that did really well. I think this “backing your Best Ideas” thing is arguably quite dangerous - it leads you to overweight on the wrong Stocks. I would say it is far better to buy Equal Weights of Stocks or to Size Positions according to Market Cap or perceived Volatility or something - and then to add to Positions if they start to move up - so in effect the Best Ideas choose themselves and the weaker Ideas are starved of Capital in relative terms.

I would postulate that “backing best ideas” is one of these Guru sayings that might be useful for Warren Buffett or George Soros but for normal run of the mill Investors it has limited use. As I covered in Part 2, it could be very much part of an Overconfidence Bias that I think is prevalent among Retail Investors. I would say it is far better (and far more realistic) to just buy a Basket of Stocks that you think are undervalued and to let them do their thing as a Collective - it is the Performance of the Portfolio that really matters, not the individual Stocks that make it up. My ‘Monkey with a Pin’ Blogs are related to these ideas on how to manage Stocks within a Portfolio - there is a link at the bottom of this Blog.

Don’t forget the Power of Momo
I am just adding in a paragraph or so here at the last minute. I think it was yesterday on a Tweet that I mentioned how I had recently listened to the ‘Conkers’ Corner’ interview with Nicola Duke and she was stressing the importance of realising that all Stocks in Uptrends have periods of Retracements (or Pullbacks if you prefer) and how it is critical to let these Retracements take their course and ride them out to really get the Big Winners. If you sell out of stuff just because it appears to have made a Peak and is then easing back, you are most likely to be selling way too early and you will get really annoyed when you see the Stock continue rising for Months and Months afterwards - another unwelcome hit to your Psychological make-up.

These Retracements are actually a healthy and necessary part of normal Market functioning - if you think about it, once a Stock has had a strong push up in the short term, the number of potential Buyers is going to fall away because everyone will think it has gone up “too far, too fast”. To entice these fresh Buyers in, the Price needs to ease back and become more attractive and once it bottoms out and starts to move up again, we get the ‘Johnny come latelys’ pushing it up ever higher.

In addition, for me as a Long Term Investor (not a Short Term ‘in and out’ Trader) it makes no sense to be selling Great Stocks in Major Uptrends if the Fundamental Valuation and stuff still stacks up. The Power of Momentum must never be underestimated and bear in mind that it applies on the Downside as well if you are in Shorting Mode, and it is vital to ride these Retracements and go with the Momo Flow.

Conclusion
I am a big believer in the importance and impact of the Psychological aspects of Investing and Trading (often referred to as ‘Behavioural Finance’) and as I am sure I have mentioned in many other Blogs and certainly on my ‘M3 Manifesto’ webpage, I see Psychology as an important discipline to master along with Fundamental Analysis and Technical Analysis (Charting) if you really are serious about making Money from the Markets - in whatever manner you do it.

Using a TopChopping Approach can help protect us against the Psychological Biases that can easily lead us to make sub-optimal or just plain bad decisions and there are clear benefits in terms of controlling Risk and supporting your Psychological well-being.

I think many People are prone to look at things with ‘Rose Tinted Specs’ - it might be lack of experience because they have never had the ‘joy’ of a proper Bear Market but I always think it is best to consider Upside and Downside Risks and to weigh them up as best we can and plan for any eventuality - in other words we should adopt Techniques / Approaches to manage our Portfolios which strike the most appropriate balance (for each and every one of us - this is an individual and largely intangible psychological thing - it is about what you are comfortable with) between keeping Risk safely under control but still enabling our Portfolios to capture Gains and beat the Markets where possible. Sadly this is not easy and it is important we realise this and do not get Overconfident and Blasé.

I know a lot of people use a very simple and psychologically beneficial approach of selling their Initial Stake after a good run up and staying in the Stock “for a Free Ride”. There is a nice warm fuzzy feeling around this although I would caution that there is a huge Risk of selling too early - but to be fair the chances are the Initial Position isn’t overly large so if you are selling out at perhaps 100% up (many people “Sell on a Double”) then you still have a lot of Dosh in the game.

I have used the device of the TopChop to illustrate various Psychological Concepts in these Blogs with a particular focus on the Real World and how they apply in practice. With some ‘Slow Thinking’ and a dose of imagination I am sure Readers will be able to relate these concepts to many other aspects of our Investing /Trading activities. I cannot stress enough about how our Brains are trying to mislead/fool us all the time - in many ways our natural and automatic ‘Fast Thinking’ is entirely working against us and this is something we really must avoid where we can - it is not easy.

It has been a challenge for me to write these but that’s a good thing as I am sure it ultimately makes for better Blogs than when it is all rather easy and I don’t need to think too much. I hope Readers have found the Series useful and don’t forget to check out the related Blogs below.

Cheers, WD.


Related Blogs

Position Sizing Blogs:

http://wheeliedealer.weebly.com/blog/the-wheeliedealer-approach-to-position-sizing-part-1

http://wheeliedealer.weebly.com/blog/the-wheeliedealer-approach-to-position-sizing-part-2-stocks

http://wheeliedealer.weebly.com/blog/how-many-stocks-should-an-investor-hold-are-you-drowning-in-stocks-or-is-there-a-drought-in-your-portfolio

Are you an Investor or a Trader?:

http://wheeliedealer.weebly.com/blog/are-you-an-investor-or-a-trader

Monkey with a Pin:

http://wheeliedealer.weebly.com/blog/pin-the-tail-on-the-monkey-musings-on-portfolio-management-part-1-of-2

http://wheeliedealer.weebly.com/blog/pin-the-tail-on-the-monkey-musings-on-portfolio-management-part-2-of-2

What is your Edge? blog:

http://wheeliedealer.weebly.com/blog/what-is-your-edge

Stoplosses:

http://wheeliedealer.weebly.com/blog/to-stoploss-or-not-to-stoploss-that-is-the-question

http://wheeliedealer.weebly.com/blog/stoplosses-for-wimps

The Price of Caution:

http://wheeliedealer.weebly.com/blog/the-price-of-caution

Dying for a P/E valuation Blogs:

http://wheeliedealer.weebly.com/blog/valuation-valuation-valuation-bursting-for-a-pe-part-1-of-3

http://wheeliedealer.weebly.com/blog/valuation-valuation-valuation-bursting-for-a-pe-part-2-of-3

http://wheeliedealer.weebly.com/blog/valuation-valuation-valuation-bursting-for-a-pe-part-3-of-4

http://wheeliedealer.weebly.com/blog/valuation-valuation-valuation-bursting-for-a-pe-part-4-of-4

Target Setting:

http://wheeliedealer.weebly.com/blog/targets-helping-improve-your-aim-part-1-of-3

http://wheeliedealer.weebly.com/blog/targets-helping-improve-your-aim-part-2-of-3

http://wheeliedealer.weebly.com/blog/targets-helping-improve-your-aim-part-3-of-3


Links to the Earlier Parts of this Blog Series:

http://wheeliedealer.weebly.com/blog/the-psychology-of-the-topchop-part-1-of-3

http://wheeliedealer.weebly.com/blog/the-psychology-of-the-topchop-part-2-of-3