January 2022

Emotional Cost of Trading/Investing

woman holding her head — Stressed by Losses

We all know that making a trade is not free – it costs money (transaction, holding costs) and time (research, analysis, trade execution). But less commonly mentioned is that trading/investing also incurs emotional costs. Stresses are incurred in almost every trade, and it is important to take this into account in order to maximize the probability of success for your trading/investing strategy.

The market has been in chaos during the past week (as of the time this article has been written). Equity and crypto markets have dropped sharply, with some assets down as much as 50%. This is most likely the most stressful period for traders and investors since the Covid crash of March/April 2020. It is periods like this that the emotional costs of trading/investing become most significant, and hence most important to manage.

What is Emotional Cost

Emotional cost of trading/investing is the collective set of negative emotions one experiences during trading/investing which causes psychological stress and may potentially lead to emotional exhaustion.

Why It Is Impossible To Avoid Incurring Emotional Costs During Trading

Emotional costs are incurred whenever a non-optimal trading/investment decision is made, as regrets are experienced for every buy or sell trade which did not result in the most money made or least money lost. It is nearly impossible to consistently make optimal decisions in trading, as trading is too complex. To make a trade in general, one has to decide on 3 things:

Direction of trade (Should I go long or short?)
Timing of trade (When should I make the trade?)
Quantity of trade (How much money should I put into the trade?)

It is literally impossible to consistently buy/sell at the absolute lowest/highest points using 100% of your buying/selling power. It is not necessary to do that in order to be profitable, but even when you have made a profitable trade, you would have some regrets over the decisions you could have made to make even greater profits. Indeed, there would be regrets in most trading situations.

For example, the regrets after a trade has been initiated are:

	Price went down after trade initiation	Price went up after trade initiation
Shorted using 100% of selling power	No regrets	Should not have shorted
Shorted using < 100% of selling power	Should have increased position size	Should not have shorted
Didn’t initiate trade	Should have shorted	Should have longed
Bought using < 100% of buying power	Should not have bought	Should have increased position size
Bought using 100% of buying power	Should have bought	No regrets

Table of Regrets

In most situations, regrets would surface. And it is unfortunate but true that the negative emotions aroused by bad trades are stronger than the positive emotions evoked by good trades. Thus overall, an investor/trader would likely experience net negative emotions from trading/investing.

Impact of Excessive Emotional Costs

Firstly, it impacts your trading/investment performance. Staying disciplined and sticking to your trading strategy is difficult when you are facing massive losses. Huge losing positions may be liquidated, even if they should be held due to fundamental/technical reasons. And worse, subsequent risky trades may be undertaken to try to recover losses, even if the risk/reward ratios are not favourable.

Secondly, it affects your mental well-being and may blunt cognitive capabilities. This would lower success rates significantly.

Lastly, there may be detrimental effects on the non-trading/investing aspects of your life. Your personal and professional life may suffer, perhaps permanently and significantly.

How Should You Manage Emotional Costs

The best way to manage emotional costs of trading/investing is to simply take them into account when deciding to make a trade. This should be done at both the individual trade position and entire portfolio level.

individual position level

Max Loss
- Determine the lowest price your stock/asset would go to (or highest price, if you are making a short trade)
- Calculate the amount you would lose at the lowest point
- Decide if you can take the loss for that trade/investment position
Daily Volatility
- Estimate the daily fluctuations in value of the position you are considering to take
- Decide if you can withstand the daily fluctuation in your position value

Portfolio Level

Max Loss
- Estimate the losses your portfolio would take in the event of a worst-case market development
- Add the max loss of the position you are considering to take to your estimated max portfolio loss
- Decided if you can take the max loss for your entire portfolio
Daily Volatility
- Estimate the daily fluctuations in value of the position you are considering to take
- Add the estimated daily fluctuation in value of the position under consideration
- Decide if you can withstand the daily fluctuation in value of your portfolio

Conclusion

The emotional aspect of trading/investing is generally under-appreciated in mainstream educational media. More coverage is placed on how to execute wining strategies and choose winning stocks. When positions are small, emotional costing may not be so significant, but it needs to be considered as soon as you start to increase position sizes. This would ensure that trading discipline can be maintained and cognitive performance is not degraded, and hence success rates can be maintained.

China Begins To Ease Financial Conditions

man turning on vintage boombox placed on red car — China Starting To Adjust Financial Policies

China has started the easing of financial policies in order to combat a slowdown in economy growth. On Monday, it cut borrowing costs of its medium-term loans. Bond yields fell as bonds became more attractive. Today, it has made more cuts to various lending rates. These moves are intended to increase borrowing by firms and stimulate the Chinese economy.

This could be the start of a period of sustained policy easing, which would stabilize market sentiment for Chinese-related stocks and make it a good entry point for beaten-down stocks. Indeed, HK property and tech stocks have soared. But no one really knows how much policy easing will occur and in what form, as China remains concerned about having too much debt.

This is not an all-clear signal to buy any Chinese-related stock, there still needs to careful select of sectors and stocks which are most likely to take advantage of the stimulus. Do take control of any greed creeping in, catching falling knives is really enticing but some knives may drop further.

Do Bonds Still Have A Role In Your Portfolio?

Bonds have traditionally acted as a bastion of stability in a portfolio. They are resilient to market fluctuations, and can provide a modest but reliable source of recurrent income. But given that interest rates are most likely going to rise in the next few years, bond prices are slated to fall. Do they still have a role to play in your portfolio?

body of water — Bonds act as anchors in tough times

What Are Bonds?

A bond is basically a loan made to companies or governments. They generally pay a fixed interest rate over a set period. It is effectively an IOU which can be transferred to different parties. When you buy a bond, you are taking over a loan made to the company. You will receive regular payments from the company until a date stipulated in the bond contract. If you would like to know more, Forbes has a nice write-up on it.

How Are They Valuable To You?

They are very valuable whenever there is a market downturn. When equity prices drop drastically, bond prices will tend to be stable, and continue to provide recurring income. This has immense psychological value and tactical value.

Psychological value

Your portfolio is a lot more stable than a 100% equity portfolio. Portfolio value fluctuates less, thus there is a lot less emotional cost. When stocks drop > 5% and your bond values barely changed, you would feel much less of a hit. You would be able to sleep better and make less impulsive decisions.

Tactical value

You have the option of selling away your bonds to take advantage of depressed equity prices. The recurring income is also more assured than the dividends from equities.

Why Are They Less Favorable During This Period?

Interest rates are projected to rise over the next few years. This would make bonds less attractive, as the interest rates they pay out (ie. yield) would be closer to general market rates. For example, a yield of 3% would seem very attractive compared to a 0.5% fixed deposit rate, but not so if compared to a 2.5% fixed deposit rate.

Are They Still Useful During This Period?

Yes – personally I feel they are still useful and relevant to any portfolio. Their psychological and tactical values are not totally nullified by the rising interest rate environment, and they are still extremely valuable during periods of heightened volatility. The key is to select bonds which are less affected.

Short duration bonds (bonds maturing in < 2 yrs)
Bonds with relatively high yield, perhaps > 4%, and having its yield adjusting to inflation

The key risk to consider is that rates increase faster and in greater magnitude than expected. This would put more downward pressure on bond prices. Balanced against that is the chance that inflation recedes, and interest rates remain low, which would improve the outlook for bonds.

If wholesale bonds in $250k denominations are not your cup of tea, you can consider bond funds/ETFs. As always, please do not invest 100% of your portfolio in a single asset/asset class, and select reasonably safe bonds from entities which are not in financial distress.

Is Iron Ore Ripe For A Pullback?

Iron ore is used in the production of steel. China is the dominant user of iron ore, and imports it mostly from Australia and Brazil. Like many commodities, it is highly volatile. Prices often overshoot and undershoot fundamentals by a large degree.

Last May (2021), benchmark iron ore prices reached a record high of around $233.10 per metric ton. It subsequently plunged below $90 in Nov 2021, before staging a steady rebound. The price as of today is about $124.

The rebound was driven mainly by expectations of higher demand this year. However, there is no certainty of actual demand meeting these expectations. There are too many forces at play affecting both supply and demand to be able to accurately predict future price. Some of these forces are Chinese property sentiment, policy developments on infrastructure, weather and mining output curtailments.

Iron ore stocks have rebounded by as much as about 50% based on this optimism. If the optimism proves to be unfounded, expect the prices to retrace. It may be opportune to take a small bet against iron ore, or monitor closely for developments in the sector to gather more clues on future trend before entering a position.

Comparison Of Shorting Methods

Shorting is a good skill to add to your trading skillset, as it allows you to take advantage of a wider array of market conditions, and also increases the variety of strategies you can employ. There are many methods of shorting the market. The most common are:

Buy put option
Sell call option
Sell via CFD

Buy Put Option

Description	Purchasing the option to sell an asset at a certain price by a certain date
Characteristics	Breakeven point is a moderate distance away, thus probability of a trade being profitable is significantly lower than 50%. As downside is capped while upside is unlimited, the magnitude of wins are much larger than losses.
Typical win/loss pattern	Many small losses, few big wins
Preferred Market Conditions	Volatile environment where moves are relatively large, so that it is easier for you to reach breakeven point, and upside potential can be maximized
Pros	Highest profit potential, profits can be several multiples of capital invested. Losses for each trade are capped.
Cons	Highest risk, entire capital sunk in a trade can be lost. Value of option declines over time. May be difficult to accurately assess win rate and risk/reward ratios and balance them optimally, as calculations for options can be complex.

Sell Call Option

Description	Selling the option to others so that they can buy an asset at a certain price by a certain date
Characteristics	Breakeven point (for the person buying your option) is a moderate distance away, thus the probability of a trade being profitable is significantly higher than 50%. As downside is unlimited while upside is capped, the magnitude of losses are much larger than wins.
Typical win/loss pattern	Many small wins, few big losses
Preferred Market Conditions	Stable environment where moves are relatively small, so that it is difficult for the person who bought your option to reach breakeven point, and the number of losses can be minimized
Pros	Option position will earn more money over time due to decay of option value for the person who bought your option.
Cons	A single loss can be huge and completely wipe off gains from many successful selling of call options. May be difficult to accurately assess win rate and risk/reward ratios and balance them optimally, as calculations for options can be complex.

Sell Via CFD

Description	Establishing an agreement to sell an asset at the current price, and buying it back at a future price
Characteristics	Breakeven point is a short distance away, thus the probability of a trade being profitable is slightly lower than 50%. Upside and downside are balanced, unless stock price increases more than 100%. Downside is theoretically unlimited while upside is capped at 100%. Downside would breach 100% once the stock price increases more than 100%.
Typical win/loss pattern	Wins and losses are about equal in magnitude and frequency.
Preferred Market Conditions	Stable to moderately volatile environment, where stock price gains do not exceed 100%.
Pros	Relatively simple pricing mechanism makes it easier to accurately assess win rate and risk/reward ratios, and balance them optimally.
Cons	Holding CFD positions will incur financing charges, thus it may be expensive to hold them for too long.

Conclusion

In theory, different trading conditions would be best served by different shorting techniques. In practice however, many traders do not employ all the techniques. They usually stick with either options or CFDs. For beginners in shorting, I would recommend to try out both and find the one which fits your style better.

Good luck!

Omicron Found in 2nd China Port City

China has just found Omicron in Dalian, a major port city. Omicron has now spread to 2 major Chinese port cities. This may cause global supply chain issues to worsen as movement restrictions are imposed, and add to inflation.

This development is not market friendly, as higher inflation will cause faster central bank tightening. US and European market futures are slightly red, so there isn’t a major impact on general market sentiment yet.

If you are trading, you probably need to monitor closely whether it worsens and brings down the markets in a significant way.

Effect of The Impending Earnings Season

Just a quick note to serve as a gentle reminder. The earnings season will start this Friday with the reporting of the big US banks like JPMorgan Chase and Citigroup. This adds an element of unpredictability to the markets, as no one can be certain of how an earnings report will turn out.

If you are initiating a trading position and planning to hold for at least a few days, do take into account of the added unpredictability. Earning reports can sometimes have more effect on a stock/sector/overall market than fundamental factors, even if the reports seem to be less relevant.

Good luck!

Has The Fed Minutes Release Killed The Global Market Rally?

The Feds released the minutes of their December meeting 2 days ago. It was more hawkish than expected, with ultra-easy conditions slated to end faster. Markets have reacted negatively to it, but are still very close to all-time highs.

This is going to be a long-term drag on market sentiment. The balance of market forces have changed. With policy now acting against the market, coupled with sky-high valuations, the probability that the red-hot market rally will end is now high than ever.

In my humble opinion, it is best to minimize exposure to stocks which have run up a lot, and also stocks with high gearing ratios. If you have high conviction that a stock will fall, you can also consider shorting it.

2022 S&P Targets

It’s time once again to rev up for the new year!

dashboard with control and measuring devices in automobile — Revving up for the new year!

The CNBC Market Strategist Survey gave a snapshot of the predictions for S&P in 2022. In summary, the targets range from 4400 to 5330, with an average target of 4985 and median target of 5050. Given that S&P closed at 4793.54 yesterday, there is roughly upside of 4-5% according to the biggest banks in Wall Street.

Interestingly, the predictions for 2021 were included, and ranged from 3950 to 4800. This means that almost everyone got it wrong for 2021. This serves as a reminder that these price targets are really “best guesses”.

Nonetheless, the 2022 predictions indicate that the “experts” do not think that the returns of the best part of the last 2 years will most likely not be replicated. In my humble opinion, it would be prudent to rotate into other markets for better returns. Cheers!