This week we begin to look at how to get from trading incompetence to trading competence. That is, moving ‘above the line’ on our competence matrix as shown in the figure below in order to achieve consistency and objectivity in our trading. Through trading in a disciplined and mechanical approach we are now able to achieve consistent profitability and outperform a chosen market. In Australia this is the All Ordinaries Index.

At the Conscious Competence level, the individual understands or knows how to do something. However, demonstrating the skill or knowledge requires conscious effort or concentration. As more events (mechanical trades) are completed at this level, less effort and concentration is required.

With respect to trading, the individual attains the mental skills of objectivity and consistency and begins to consistently outperform the market indices. It has been proven that the highest probability and quickest way of acquiring the Conscious Competence skill level with respect to trading is to trade with a mechanical trading system that has a proven positive mathematical expectation—an ‘edge’. That is, the statistical probability of not just making profits but handsomely outperforming the market indices, is heavily stacked in your favour.

Everything we do in life, whether it be a mental or physical activity, begins with a mechanical stage of learning. This is necessary because the learning process requires that a skill first passes through the logical conscious mind for a period of time before being transferred to the subconscious mind. The conscious mind comprehends the mechanical steps involved in the activity and, in the early stages of learning the skill controls the actions to be undertaken. Through repetition, experience and a feedback loop, the necessary actions to take on the skill are transferred to the subconscious until new habits and new beliefs are formed that are in harmony with the new activity.

The degree to which the skill is transferred to the subconscious mind without the need for conscious thinking is the degree to how well the skill will be executed. The more automatic the execution the better it will be. The logical mind is good at planning and solving problems; the subconscious mind is good at executing, whether it be mental or physical execution.

The mental activity of learning to read requires that the mechanics of words be comprehended by the conscious mind. Try to read in a different language! After the logic of word and sentence structure is comprehended by the conscious mind and then repeated over and over again, the skill is transferred to the subconscious mind. The individual now has a ‘trained eye’.

The same applies to physical activities such as learning to write, crawl, walk or run. The same learning process applies to driving a motor car, hitting a golf ball, brushing your teeth and to trading the market. Many repetitions lead to mechanical comprehension in the conscious mind; eventually the subconscious takes over.

A mechanical trading system uses unambiguous criteria to determine market entry and exit points. Unambiguous means ‘no doubt or misunderstanding’, and ‘having only one meaning or interpretation and leading to only one conclusion’. The unambiguous criteria are well defined and objective thereby making the buy and sell decision simple, clear and certain, even though the outcome is not. If the entry and exit criteria are discovered through rigorous research on large samples of historical market price action, an edge in the favour of the trader can be discerned.

A mechanical trading system operates from the paradigm of market price action from whence it was researched and hence originates. Active investors using a mechanical trading system take on the paradigm of the mechanical system and make buy and sell decisions from that paradigm.

Active investors not using a mechanical trading system use their own paradigm to determine entry and exit points which operate from their own perspective. Their paradigm comes from the sum total of their experiences in their life, which is very different to the experiences of market price action. Humans are programmed by their environment and societal life experiences. A mechanical trading system with a positive ‘edge’ is programmed by market price experiences.

Societal paradigms do not work in the environment of the market; they work in the environment of society. We have discussed the difference between societal paradigms and trading paradigms in previous Blogs. Unconscious and Conscious Incompetents operate from a societal paradigm; they think from the perspective of societal living when making market decsions. Conscious and Unconscious Competent traders operate from a market paradigm; they become empathetic with the market.

It can take many years for an individual to change his or her way of thinking to that of the market’s perspective. Some will never be able to change their way of thinking for various reasons which can be discussed in future Blogs. The highest probability way of succeeding in changing is to use a mechanical trading system with a positive ‘edge’ for reasons discussed above.

It is at the Conscious Competence level that active investors begin to attain an ‘edge’ over the market where their winning trades total far more than their losing trades. Losing trades are cut short while winners are allowed to run and the portfolio equity curve continues to rise with acceptable drawdown levels. Large loss trades which are detrimental, if not fatal, to portfolios become a thing of the past.

To be consistently successful in trading, and to remain so, the individual need only remain at the Conscious Competent level. However as more mechanical trades are completed the individual will come closer to achieving the highest level of learning, that of Unconscious Competent. We will discuss this highest level next week.

Typical attributes of the Unconscious Incompetence level that we discussed last week include relying on the advice of others as the basis for making trading decisions (including brokers, the media, hot tips, chat rooms, newsletters and forums – typically referred to as ‘market noise’), and having no clearly defined and unambiguous strategy, system or trading plan for engaging the market. As a result, a very high percentage of traders and investors who embark on the active investment journey quit as losers after their first year. They bow out frustrated with the markets and with themselves and justify their actions through statements such as “the markets are rigged”, “the markets are all based on insider information” and other justifications for their inability to develop the necessary skills to achieve outperformance of the market indices.

Those who choose to persevere and to actively learn and develop the necessary skills for success will move to the next level of skills acquisition and learning, that of Conscious Incompetence. People at this level recognise and concede that they do not understand or know how to do something, This is an important step of awareness but they still do not know how to achieve competence.

At this level, in the trading arena, individuals chop and change their tools, start using technical and/or fundamental analysis software, subscribe to a newsletter or regular subscription service such as Fat Prophets or Australian Stock Report, watch stock market TV shows and experiment with different technical indicators and charting software. Because they are now paying for or paying more for their toolset and have more knowledge, they assume that they will become successful. Not so, but they have started the journey.

Their hit rate of random wins starts increasing but it is still not high enough to outweigh the loss and large loss trades and to generate a steadily rising equity curve. They are either still net losers, are profitable but still under-performing the market indices, or, at best, have outperformed but are uncertain about whether they can repeat their profitable trading. For an active investor who is putting in lots of time time, energy and effort this is unacceptable.

Their buy and sell decision making is subjective and inconsistent, using different criteria for entry into trades based on a combination of their new toolsets and the ‘noise’ of outside influences. Tips cause knee-jerk reactions and they justify their decisions based on their analysis software and newsletters. They trade this tip, let the next tip or two go, and then do the one after, each with illogical ‘gut-feel’ position sizes. They hesitate rather than act, resulting in chasing the trade and buying at a much higher price. Hesitation and reservation also cause delay in selling, resulting in eroding profits and larger loss trades than otherwise would have occurred.

In short, they lack structure, rigour and consistency in their trade selection, execution and amount of capital placed in each trade, mainly due to fear of losing or missing out.

At this level, the incompetent still thinks at the individual trade level and has not moved to the portfolio level of thinking (this topic has been discussed in earlier blog postings). They put undue significance on individual winners and/or losers, resulting in undue emotional reaction. They do not actively invest according to well organised processes that make up a well documented investment plan.

A bull market hides these inadequacies and provides a false indication of an individual’s level of incompetence which will be magnified in a bear market where large loss trades occur that wipe out portfolios. For a classic example of this, we need look no further than recent events in global equity markets. The sustained bull-run in which people of all levels of competence were able to make money came to a crashing end in late 2007. Unconscious Incompetents and Conscious Incompetents had their portfolios fall in value in line or worse than the market indices. They were to learn that their level of skill was far from adequate to consistently protect their capital and make money from the markets across a broad range of market conditions. As the old saying goes, they had mistaken a bull market for brains!

To become consistently successful in the market, the individual needs to ‘move above the line’ to acquire the level of skill that is Consciously Competent. We will delve further into this topic next week and take a look at how we begin to move to this level of competence in our trading and investing activities.

Following on from the theme we have been discussing in the past 2 blogs on the differences between well recognised societal paradigms and how they differ from a market paradigm, let’s move on to discuss the development of trading competence. This topic will feature over the next 4 weeks as we examine the 4 stages of competency development with respect to trading.

Recognising where you are at in terms of your level of competence as a trader or active investor is very important if you are to continue to learn, develop and grow as a trader and in your personal life. Many beginner traders dive head first into the market full of confidence and ego, but with very little real understanding of how the market works, and with little in the way of skill or knowledge. Whilst full of bravado and convinced that they will make their fortune trading, they have not fully developed the skill set and mental paradigms that are necessary for long term success in the markets.

When acquiring any skill, whether in trading shares or cooking an omelette, there are typically four stages of learning that an individual needs to go through to attain the highest level of competence. The starting level is Unconscious Incompetence and the final level is Unconscious Competence. These 4 levels are shown in the table below.

At the first level, that of Unconscious Incompetence, the individual neither understands nor knows how to do something. With respect to trading, at this level the individual might understand how to place buy and sell orders. He or she may also have placed many trades and even have had a few winners; randomness will always produce a few winners.

This individual may read the financial pages of the dailies, might also know of websites which provide free tools to do research, may have subscribed to one or more of them, and may even belong to trading chat forums.

Now you might be thinking that knowing and doing this much would place you at a level higher than that of Unconscious Incompetence. However, trading competence is measured by a steadily rising equity curve in one’s portfolio or portfolios that outperforms alternative investment avenues and the market indices. Achieving a steadily rising equity curve should require little or no effort, struggle, strain or pain. Having the skills stated so far will not achieve a steadily rising equity curve let alone doing so with little or no effort, struggle, stain or pain.

In short, people at this level may know what to do but cannot do what they know.

That’s because Unconscious Incompetents have no system, no strategies and no plan. They dabble in the market, probably only place trades erratically and when they do it is usually in reaction to a share tip generated from the ‘noise’ brigade that surrounds the market: tips from friends, brokers, magazines, TV shows, newsletters, chat forums or newspapers. This is not to say that these tips won’t rise in price. The problem is that their buying opportunities come from outside influences rather than from inside strategies that are a part of their well-oiled plan. There is no structure or process. There are no exit strategies or position sizing rules.

At some stage, the pain of large loss trades, constantly missing the solid movers and an equity curve that is either going nowhere or heading south eventually causes the Unconscious Incompetent to give up or to do something about it.

Either of these responses is acceptable. The response that is unacceptable is an individual succumbing to the Dunning-Kruger effect—December 1999 Journal of Personality and Social Psychology (Vol. 77, No. 6). This is the phenomenon whereby people who have little knowledge systematically think that they know more than others who have much more knowledge. This is fatal in a zero-sum game like trading: what one individual loses another gains—the incompetent individual loses to the competent individual.

The Dunning-Kruger effect states that incompetent individuals:
• tend to overestimate their own level of skill,
• fail to recognise genuine skill in others,
• fail to recognise the extremity of their inadequacy.

Further, if they can be trained to substantially improve their own skill level, these individuals can recognise and acknowledge their own previous lack of skill.

A quote from Mark Twain made many years ago might have saved or motivated Messrs Dunning and Kruger’s research: “What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.”

At this level, individuals don’t know what they don’t know. They believe what they do know is sufficient to be successful at what they are doing. Succumbing to the Dunning-Kruger effect is unacceptable because individuals do not give up; they continue to trade while remaining at the level of Unconscious Incompetence. And they continue to lose to those who are competent. The result is a transfer of wealth from the unprepared to the prepared. The goal for those at this level is to develop their level of competence.

Those who persevere and do something about it will probably move to the next level of skills acquisition and learning, that of Conscious Incompetence, Level 2 on the matrix of competence. Next week we will examine and discuss the characteristics of this level as it relates to the trading arena.

Continuing from last week’s topic “societal paradigm vs market paradigm” I’ve used another 3 examples of how our social paradigm can deter us from success in the market. Whilst the societal paradigms that we learn and adopt as part and parcel of our involvement in society stand us in good stead to co-exist amicably (most of the time, i.e. we have an edge!) with our fellow human beings, they are not always the best skills for engaging the market in a consistent and profitable manner. Indeed many of these market paradigm examples required to be a successful trader and investor are actually counter-intuitive to how we interact in society on a day to day basis and hence are paradoxes.

Societal Paradigm: The need to be bigger faster vs Market Paradigm: Process determines price and speed.

Most people in the western world want more and they want it now! People look for bigger houses and faster cars to display to society how successful they are. This bigger, faster attitude of instant gratification can be suicidal in the markets without an understanding of processes.

A successful investor determines the size and speed at which to invest in the market before undertaking a strategy. Their trading plan and tools determine how much capital to put at risk and over what period. By predefining their process and strategy prior to engaging the market they are able to follow their predetermined rules in the heat of the market. Without a set of predefined rigorous and unambiguous processes the investor can be side tracked into running to bigger and faster instruments driven by greed. This manifests itself in the form of position sizes that are too big for the investors account and overtrading as the trader/investor goes flat out to attempt to produce instant results – and usually destroys their account in the process.

Societal Paradigm: Wants the in vogue stock vs Market Paradigm: Any stock that meets the rules is OK.

Can you remember the Telstra float in November 1997? Mum and Dad investors lined up to own a piece of the big telco in the hope that a future gain would be made. This is one of the many “herd” examples that drive the uneducated to in-vogue stocks simply out of a fear of missing out. This is also seen when a stock suddenly becomes a ‘market darling’ through the discovery of a mineral deposit, a cure for the common cold or other similar news driven story. The punters rush to get on board in fear of missing out and prices are pushed to ridiculous extremes before imploding and catching the unwary punter completely off guard.

An educated investor predefines his/her entry and exit criteria before entering a trade, even an in vouge one. Their criterion is not built around the name of the stock, the hearsay from media or the size of market cap but comes only from market price action. The educated investor reacts to what is happening in the market rather than trying to predict what may happen in the future.

Societal Paradigm: Reacts to negative outcomes with frustration, anger and revenge vs Market Paradigm: At peace with outcomes, whether up or down.

This is seen many times over in society and a classic example is road rage. Making a mistake on the road through lack of concentration or the ability to follow the road rules can lead to a negative reaction from other drivers. Surrounding drivers will make their frustrations known and can even display anger and or seek revenge. People involved in road rage incidents have actually been harmed because they made a concentration error on the road.

You’ll have more than enough loss trades in the market to use as a negative outcome. If you choose to react with frustration, anger and revenge in the market your judgement will become clouded and you’ll find it almost impossible to stick to a predetermined process. You will most probably compound mistakes and losses by trying to get even with the market. Developing empathy with the market and accepting that losing leads to success over the long term is perhaps one of the most important aspects of the ongoing education of traders and investors. There is no point in getting angry. As discussed in a previous blog, anger makes you stupid. A classic quote that I read somewhere: “The measure of a man is how long it takes him to get angry.” Accepting losses and moving on to the next trade with no ‘baggage’ is the mindset needed for success.

Next week I plan to outline the four stages of learning that an individual needs to go through to attain the highest level of competence.