(or “AH-HA”s for Traders)
By Van K. Tharp, Ph.D
October 29, 2018
A note to readers: While Van’s content is timeless, it is from a past publication and may contain outdated information, missing links or images.
When the topic of paradigm shifts came up at a workshop, I suddenly started talking about all the paradigm shifts that were in my book Trade Your Way to Financial Freedom. I had never before thought about the book in terms of paradigm shifts, but suddenly all of the information about the shifts discussed in my book was pouring out of my mouth. After being totally amazed, I decided to spend some time thinking about what I’d said. At the time of the workshop, I remarked that there were four major paradigm shifts in my book. I have no idea where that number came from, but I was able to elucidate four of them very well. Since that time, with considerable thought, I’ve only been able to come up with two more. Nevertheless, these are major paradigm shifts for most traders and investors.
Trading success has very little to do with what’s outside of you, such as what the market does. Instead, you must determine who you are and what your objectives are. Once you have done that, you can design a trading system that fits you.
Most people believe that trading success has to do with the markets, with indicators and analysis, and with finding some magical edge that will help them perform slightly above their competitors. This is totally wrong! Instead, trading success is an inner search. It has to do with finding yourself. Who are you and who do you choose to be? When you’ve answered those questions, you can then decide how to express the new you through the markets. However, this is a major decision. Most people give it no credence or, even when they are aware of it, no time.
There is no Holy Grail in the markets outside of you. But there is a Holy Grail and that comes from developing a trading system that fits you. When you do this you can do much more than outperform the majority of market players. You can achieve levels of performance that others might think are impossible.
Academic psychology is full of people who have done marvelous research studying the shortfalls of the average trader. As a result, economists are beginning to say perhaps the markets are not efficient. And, perhaps by studying human frailties, one can begin to predict how the markets are not efficient. Thus, the field of behavioral finance has been born.
I consider myself to be a student of behavioral finance and one of the few people who is really helping others to apply it. However, applying behavioral finance doesn’t mean predicting the inefficiencies in the market. Applying it means working on yourself to make sure you don’t have these inefficiencies. However, that is too much of a major shift for most people who are into what the markets are doing. But, when I talk about traders making consistent 50-100% returns in the market with little risk, the people who believe it is all outside of themselves think we’re doing the impossible.
You don’t have to predict the market to make money. Instead, making money comes from controlling your exits.
I’ve discussed this one extensively many times. The golden rule of trading is “Let your profits run and cut your losses short.” What does that have to do with prediction? Absolutely nothing. Instead, it has everything to do with getting out of the markets using a systematic plan. Enough said! However, this one can stimulate an argument in many of my students—even those who have read Trade Your Way to Financial Freedom several times and think they understand it.
The fourth paradigm shift is simply an elaboration of the third.
You don’t have to be right to make money. Instead, you must understand R-multiples, expectancy and opportunity.
Suppose you trade high priced stocks that are going up consistently. You get into the stock, but get out immediately if it goes against you by more than $1. Thus, your risk per share is $1, which I’ve defined as 1R.
Suppose you enter a rising stock and get stopped out. You’ve lost a dollar or 1R. Suppose this happens five more times. You’ve now had six 1R losses. On the seventh trade, the stock takes off on you. You ride the stock for a $30 profit. That’s a 30R profit.
You’ve now had seven trades—six 1R losses and one 30R profit for a net of 24R. Let’s even say that your transaction costs amount to 0.5R per trade, so we must subtract another 3.5R. Even now, we still have a total profit of 20.5R. If that’s your average for seven trades, what if you make 21 trades each month? You’d have a profit of 63R while being right on only about 14% of your trades.
If you have not made this paradigm shift yet, you’ll probably find all sorts of reasons to refute the logic of my example. I’ve heard them all. And all of them have come from people who were having trouble with this paradigm shift and needed to defend their position.
Big money does not come from any of the factors that most investors and traders focus their attention upon. Instead, big money comes from having a position sizing strategy that is designed to meet your objectives.
Let’s use the example given above. Suppose you risked 0.5% of your equity on every trade. After six losers in a row, you’d be down about 3%. However, after your 30R gain, you would be up 12%. And in the scenario above (even assuming huge transaction costs of 0.5R or 0.5% of your portfolio), you’d be up over 30% in a single month on 21 trades.
Again, if you haven’t made this paradigm shift, you’ll find lots of flaws in my logic to support your position. That’s okay and it won’t bother the people who regularly make big profits while giving up being right.
Let’s assume that three 30R trades in a month is unrealistic. Three 15R trades is not. It would still give you a net profit of 27R per month. That’s 13.5% with our 0.5% risk per trade scenario. And, let’s add in the unrealistic transaction costs. That would give you a net return of 16.5R per month—or 99% per year. And again, you are still only right 14% of the time and not risking more than 0.5% of your account per trade.
While my purpose in writing this article has simply been to get you to think and step outside of your own perspective, I’d like to point out that I’ve only scratched the surface on the paradigm shifts most of you could make. There are probably at least five major paradigm shifts (not covered in this article) in each of the volumes of my Peak Performance Course for Traders and Investors.
How to Make Your Own Paradigm Shifts
One of the greatest skills I can give you is the ability to make your own paradigm shifts—to look at the box you’ve put yourself in by your thinking and then step out. For those of you who would like maximum benefit and are really willing to “go for the moon,” here is a five-step program for creating your own paradigm shifts.
Step 1: Examine who you are and what you are doing from multiple perspectives. NLP (Neuro-Linguistic Programming) suggests that there are at least three perspectives of every event: your perspective, another involved person’s perspective, and the perspective of an outside observer watching what is going on during the event. If you were to continually observe yourself from perspectives two and three, then it would not take long at all to jump out of the box.
A simple exercise you might do is to simply replay each day at the end of the day from the perspective of an outside observer. Amazing changes will occur in you when you do so.
Step 2: Examine your beliefs. Your beliefs might form a set of concentric circles. In the middle are the beliefs that you know are true. Around that are the beliefs you think are true. The next circle contains beliefs that might be true. The fourth circle contains the beliefs that you have real doubts about—things on the fringe like the existence of ghosts or UFOs. And the final circle might be beliefs that you know are not true.
Most people tend to spend their lives rejecting beliefs on the outside of the circle and finding evidence to support the beliefs on the inside. There is even a journal called The Informed Skeptic, which devotes itself to debunking fringe beliefs. While I’m all in favor of questioning fringe beliefs, I think the beliefs that are probably the most damaging are the beliefs in the inner circle—those we know to be true. Spend time questioning those beliefs and you’ll begin to make major paradigm shifts. In fact, try questioning one or two of your major assumptions about life that you know are true. What would life be like if those assumptions were not true? Questioning of this sort is what would be most profitable and evolutionary for most people.
Step 3: Notice your projections. One of my true beliefs that is on the “fringe” for most people, has deep psychological underpinnings. It is that what you see “out there” really reflects what is going on inside of you. If you operate as if the world is a mirror to your own mind, then you will really begin to find out what your boxes are. And when you know where a box is, it is a simple step to get out of the box and make a paradigm shift.
Step 4: Keep a daily journal of your emotions and experiences. One of the best ways to observe yourself is to look at the way you were at some prior point in time and to compare that version of you with another version. You can do this through journaling and reading your journal on a regular basis. Doing so will really help you observe your paradigms and then step out of them.
Step 5: Meditate regularly. Meditation is all about listening. When you listen, you get intuition and immense guidance. As a result, twenty minutes of quiet meditation is probably the best thing you can do for yourself. Simply pay attention to your breathing for twenty minutes. Think of breathing in as “inspiration,” for it very well may be that. And when any thoughts come to you, simply notice them and let them go. If you get stuck in your thoughts, when you notice that, let it go and return to watching your breath.
These five steps should help you to make immense paradigm shifts on a regular basis. Plan to do it for the next 30 days.