Over the past 20 years I have spent much time meeting, researching, interviewing, and otherwise picking the brains of traders and investment managers. Most of them could talk your ear off about their discipline and the rationale supporting it.
Ultimately, any investing or trading discipline requires that you recognize your edge and execute your strategy to exploit your edge most efficiently. Recognizing your edge is epistemological: how do you know you really have one? Compared to whom (or what)? How long does it last? How would it do in up/down markets? Strong/weak economic growth? Is it sensitive to inflation? Volatility? Trading volume? Calendar effects?
There are not necessarily any “right” answers, but two types of answers spell potential trouble: hubris and inconsistency. The brightest and longest tenured investors I’ve met have all exhibited an unapologetic dose of humility, recognizing they weren’t infallible. One mindful hedge fund manager once explained to me that if a position fell by more than a certain percentage, she would sell it, reckoning she could always decide to buy it back again later but for the moment might have missed something. She also was willing to buy put options in case her thesis turned out wrong. Later that same day a different, better established manager in the same category ranted for 10 minutes about why his thesis on a certain losing position was still correct, even though it had caused his fund to suffer a nearly catastrophic loss the previous quarter. He scoffed at the notion of ever buying put options or any other form of protection. His fund was out of business within a year.
Sometimes traders and portfolio managers could stand to brush up on the mathematics of money management. The writing of Ralph Vince comes to mind. Understanding concepts like “risk of ruin” and “Kelly criterion” are required for anyone with fiduciary duty. Similarly, grasping the effects of leverage on any system is crucial. Too many investors’ so-called “risk management” protocols are simply ad hoc habits, instead of well-reasoned disciplines. In the book Fortune’s Formula, Ed Thorp (best known as author of Beat the Dealer, but also a successful hedge fund manager) admitted to being so averse to overestimating the value of his information that he would estimate his optimal position size and then invest only half of it. Humility again.
I know a stock investor with an impressive system for precisely identifying individual stocks’ upside and downside price potential, and he only buys if the upside/downside ratio exceeds a certain threshold. He religiously sells positions that eclipse their upside target but holds on to anything that doesn’t. In effect, he lets his losses run. I pointed out his cognitive dissonance: he respects his downside target enough to affect the buy decision, but not enough to affect the sell decision. Even though he might be buying stocks that don’t necessarily have negatively skewed distributions, his sell “discipline” effectively reshapes their distributions to be negatively skewed. This is the kind of portfolio dynamics risk that doesn’t show up in a performance attribution, no matter whose risk model you’re using.
Having investment information doesn’t automatically translate into profits, but with proper systems of implementation and risk management you have a fighting chance.