Why Checklist is important in Trading

The Checklist Manifesto by Atul Gawande inspired me to write this article about humans’ fallibility in trading. 

Atul is a surgeon and he was appalled that despite availability of cure, studies have found that in a majority of cases, patients of critical ailments fail to receive complete or appropriate treatment.

Due to societal advancements, things have evolved over time from Simple to Complicated and then Complex. As the human brain is limited by the number of details and considerations it can attend to at any one time, it leads to skipping steps in the process and errors are committed.

The solution to this is simple – It is a checklist.

Atul discovered the works of checklists in the airline, construction, culinary and investment industry. Personally I am particularly interested with how checklists can help with our investments. Below is an excerpt from the book and a good story to illustrate.

Some years ago, Geoff Smart, a Ph.D. psychologist who was then at Claremont Graduate University, conducted a revealing research project.

He studied fifty-one venture capitalists, people who make gutsy, high-risk, multimillion-dollar investments in unproven start-up companies. Their work is quite unlike that of money managers like Pabrai and Cook and Spier, who invest in established companies with track records and public financial statements one can analyze.

Venture capitalists bet on wild-eyed, greasy-haired, under-aged entrepreneurs pitching ideas that might be little more than scribbles on a sheet of paper or a clunky prototype that barely works. But that’s how Google and Apple started out, and the desperate belief of venture capitalists is that they can find the next equivalent and own it.

Smart specifically studied how such people made their most difficult decision in judging whether to give an entrepreneur money or not. You would think that this would be whether the entrepreneur’s idea is actually a good one. But finding a good idea is apparently not all that hard. Finding an entrepreneur who can execute a good idea is a different matter entirely.

One needs a person who can take an idea from proposal to reality, work the long hours, build a team, handle the pressures and setbacks, manage technical and people problems alike, and stick with the effort for years on end without getting distracted or going insane. Such people are rare and extremely hard to spot.

Smart identified half a dozen different ways the venture capitalists he studied decided whether they’d found such a person. These were styles of thinking, really. He called one type of investor the “Art Critics.” They assessed entrepreneurs almost at a glance, the way an art critic can assess the quality of a painting—intuitively and based on long experience. “Sponges” took more time gathering information about their targets, soaking up whatever they could from interviews, on-site visits, references, and the like. Then they went with whatever their guts told them. As one such investor told Smart, he did “due diligence by mucking around.”

The “Prosecutors” interrogated entrepreneurs aggressively, testing them with challenging questions about their knowledge and how they would handle random hypothetical situations.

“Suitors” focused more on wooing people than on evaluating them. “Terminators” saw the whole effort as doomed to failure and skipped the evaluation part. They simply bought what they thought were the best ideas, fired entrepreneurs they found to be incompetent, and hired replacements.

Then there were the investors Smart called the “Airline Captains.” They took a methodical, checklist-driven approach to their task. Studying past mistakes and lessons from others in the field, they built formal checks into their process. They forced themselves to be disciplined and not to skip steps, even when they found someone they “knew” intuitively was a real prospect.

Smart next tracked the venture capitalists’ success over time. There was no question which style was most effective—and by now you should be able to guess which one. It was the Airline Captain, hands down.

Those taking the checklist-driven approach had a 10 percent likelihood of later having to fire senior management for incompetence or concluding that their original evaluation was inaccurate. The others had at least a 50 percent likelihood.

The results showed up in their bottom lines, too. The “Airline Captains” had a median 80 percent return on the investments studied, the others 35 percent or less. Those with other styles were not failures by any stretch—experience does count for something. But those who added checklists to their experience proved substantially more successful.

Our life experience and education drives us to learn how to manage certainty; whereas in trading, uncertainty prevails. We need to learn to manage uncertainty – the main cause why so many smart people act dumbly in the market and fail.

In addition to faulty memory and attention, cognitive biases tend to short cut our supposedly “rationality” to jump the gun and costs us dearly in the market.

We inherited emotional reactions, aka “instincts”, from our ancestors to save us from danger, yet it becomes disadvantageous when we become stressed trading in the market.

Trading rules are simple:

1. Buy low and Sell high (long) / Sell high and Buy low (short).
2. Let the profit run.
3. Cut the loss short.
4. Apply proper risk and money management (to stay in the game first, then money will come later).

Yet, very often our results are:

1. Buy high and Sell low.
2. Cut the profit short.
3. Let the loss run.
4. Lack of sound risk and money management.

Why? The short answer is that our instinct short cuts our rationality to drive us to act dumbly in the market.

To become a consistently winning trader, the advice consists of “controlling our emotion”. How?

Can we really control our emotion? Of course not, it is easy said than done.

The reality is to learn to be “aware” of our emotional reactions, once we have the awareness, it becomes easier for us to hold back and think to make rational decisions. Using checklist will certainly help.

Rules are sets of explicit or understood regulations or principles governing conduct within a particular activity or sphere. In other words, they define acceptable behaviour and are to be used in specific environment and conditions.

The success formula in trading is the rule of 3 “M”s – Method (M1), Money (M2) and Mind (M3).

As a result, we apply trading plan (the trader’s checklist) to help create the awareness and to avoid the dumb decisions.

The trading plan is different for different people, because of our unique personality. There is no universal trading plan that suits everyone.

Steps to build a consistently winning trading plan:

1. To find a method (M1) that suits me as an individual – scalping, day-trading, swing trading, or long term investment.
2. Test the method to understand its “edge” – positive expectancy.
3. Test the method to develop the required confidence. Without confidence, we give up easily. Persistence comes after confidence.
4. Find the money (M2) that matches my trading capital and my personality. What is my risk tolerance? Can I be calm if I have drawdown, realized or unrealized, of XX% of my capital? XX% is the absolute dollar value converted into the percentage of my trading capital. It is the amount that I do not feel stressful, in case I lose such amount.
5. Find out anything about my mind (M3) that will upset my trading performance – What are the triggers that will cause me to act irrationally?

Well, the steps sound logical, yet, they are hard to measure (how to quantify?)

The simple tool to use in all of the above steps is called the journal. Journal is a time sequenced record of trading events, including entry point, stop loss point, take profit point, the reason to enter, changes made while the order is open and why make such changes and when, etc., etc.

If I make a winning trade, there is nothing to learn from the journal, if I loss, reviewing the journal will certainly help to learn from the mistakes and to improve for the future.

It is a known fact that few people treat journal seriously. The main reason is that the journal does not provide instant gratification.

The benefits of the journal:

1. Historical record – it will provide the state of my trading account at a glance. It is my personal performance database.
2. Planning tool – the journal becomes a way for me to record my thoughts in actual numbers, and makes it possible to convert wishful thinking into practical reality.
3. Methodology verification – over time, it will verify my trading methodology, it will show my system win rate, and my win to loss ratio, hence my edge/expectancy.
4. Mind pattern modification – it is a tool to change my habits from destructive to constructive. As I learn how to trade my plan, I shall develop a greater level of confidence. My profitable trades won’t feel so random, and my losses will be “planned for”.

How to set up the right journal? This is a heavy subject and deserves an entire article by itself.