The Open Curriculum

The Market · Level 2

What I Learned Losing a Million Dollars

Jim Paul and Brendan Moynihan · 1994

Thesis

There are countless ways to make money in markets but only a few ways to lose it, so the most useful study is of losing: losses come either from errors of analysis or from psychological barriers that stop people acting on their analysis, and the worst of them come from treating a position as a matter of personal pride.

The main ideas

The fall

Jim Paul rose from a small town in northern Kentucky to become a governor of the Chicago Mercantile Exchange, sitting on its board and executive committee. In 1983 he built a large position in soybean oil futures. The market moved against him, and rather than cut the loss, he held on, convinced he was right.

He lost about $1.6 million, including other people's money as well as his own. In his own account, within a year he had lost his fortune, his job, his seat on the exchange's board and his standing in the industry.

The book, written with Brendan Moynihan and first published in 1994, tells this story in its first part and draws the lessons in its second. Paul later worked as a senior executive in energy trading at Dean Witter and died in 2001.

Implication: success and expertise do not protect against a loss driven by refusing to admit a mistake. If anything, past success makes the refusal more likely.

Study losing, not winning

The book's central argument is that people try to learn from success, studying how great traders and investors made their fortunes. But successful people made money in many different and often contradictory ways, so imitating them gives little guidance.

Losses, by contrast, have only a few causes. Investors lose money either because of errors in their analysis or because psychological barriers prevent them from applying it. The second cause is far more common: people often know what they should do and fail to do it.

The mechanism is that avoiding the shared causes of loss is achievable for anyone, while copying a particular winner's method depends on circumstances that cannot be reproduced. Paul and Moynihan argue that learning how not to lose comes before learning how to make money.

Implication: when you study markets, spend more time on why positions fail than on why famous investors succeeded, and focus on the psychological failures that override good analysis.

Internal and external losses

Paul and Moynihan distinguish two kinds of loss. External losses are of things outside oneself: money, a bet, a game or contest. Internal losses are of things within: self-control, self-esteem, love, peace of mind. "External losses are objective, and internal losses are subjective."

The danger lies in treating an external loss as an internal one. A trader who sees a losing position as a loss of money can close it and move on. One who sees it as a loss of self-esteem, proof of being wrong or foolish, will do almost anything to avoid admitting it, including holding on until the loss becomes catastrophic.

The mechanism is that money can be replaced while a sense of self feels irreplaceable, so people fight far harder to avoid an internal loss than an external one.

Implication: when a position goes against you, describe the loss to yourself only in money. Keep your judgment of yourself out of it.

The stages of loss

The book adapts the stages of grief, denial, anger, bargaining, depression and acceptance, to losses in the market. A trader facing a loss first denies it, refusing to believe the market's verdict. Then comes anger, at the market, at others or at oneself. Then bargaining: deciding to get out if the price just returns to where it was. Then depression, and finally acceptance, often forced, as when a firm liquidates the trader's position.

Paul recognized each stage in his own collapse. The stages delay the decision to cut a loss, and every day of delay makes the loss larger.

The mechanism is that these are natural responses to loss in any part of life, but in a market each stage costs money, because prices keep moving while the trader moves slowly toward acceptance.

Implication: learn to recognize denial, anger and bargaining in yourself when a position goes wrong, and treat them as signals to act, not to wait.

Personalizing positions

The book's most important warning is against personalizing. Traders come to see their profits and losses as a measure of their intelligence and worth. A profit proves they were right; a loss proves they were wrong.

This produces two predictable errors. Traders take profits too quickly, to lock in the feeling of being right, and hold losing positions too long, to avoid the feeling of being wrong. Personalizing success is as dangerous as personalizing failure, because a string of wins persuades a trader that he cannot be wrong. That, Paul concludes, was his own path to ruin.

The authors also distinguish among kinds of market participation, investing, trading, speculating, betting and gambling, and argue that losses often come from confusing one activity with another.

Implication: decide before entering a position what would prove it wrong and at what point you will exit, write it down, and follow the plan regardless of how you feel about being right.

Limits

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