Get Rid of That Gut!

Good trading technique isn't difficult to master. Using it consistently over time, however, is quite a bit more difficult. Whether it's setting proper stop-loss orders or trading appropriate size, the rules of the game never change — it's discipline that ebbs and flows.

It's for this reason that I'm positively, unequivocally and unwaveringly against "going with your gut" when managing a portfolio. Human instinct tends to lead people straight to the poorhouse.

Disciplined trading comes from the head, not the heart. When you follow your instinct and go with your gut, it's usually your feelings that are leading the way. Emotional trading tends to be more irrational — and more expensive. When XYZ is 10 points against you and you're stricken with fear about taking a loss, it's your gut, not your brain, that foolishly encourages to you add a few thousand shares and hope for a comeback.

But your gut isn't just undisciplined — it's usually dead wrong. As we pointed out last week, it often doesn't matter which stock-market indicator you use, as long as you use it consistently. But trading with your gut is completely arbitrary, and far too often influenced by extraneous factors unrelated to the market itself.

For example, say you're up 10% in a winning trade with XYZ. And although your indicators are bullish and you're trading with an appropriate size, you can't help but overhear the bearish buzz circulating among analysts, in magazines and on message boards. With so many opposing voices in your ear, it's easy to second-guess your own disciplined decision making. So instead of trading with your brain and letting your winner run, you "go with your gut" and cash out just as XYZ continues its upward climb.

Moreover, relying on instinct over discipline prompts one to abandon the technique that helps keep risk to a minimum. For example, although they theoretically understand the importance of consistent position sizes, when investors trade with their gut, they tend to allocate capital in a subjective and inconsistent fashion. Usually, the stocks they believe to be "risky" get smaller allocations than the ones they believe to be "safe." Of course, what inevitably happens is that the risky stocks outperform the safe ones, but because of the inconsistent allocation, the portfolio as a whole loses money. The point is that while a disciplined plan keeps your portfolio organized, trading with your gut puts it in shambles.

But while trading with instinct is dangerous, it's also seductively easy — regardless of portfolio size or level of expertise. We've all done it at one time or another, for a variety of reasons:

After a series of winning trades, for example, we sometimes get cocky and feel as if we're trading on the "house's money." Thinking we've got the magic touch, we start to trade on "feeling." Sure, nevermind the trade has gone south and we're leveraged to the hilt. We've got a feeling the market is about to turn in our favor. Famous last words.

Or we get lazy. At its worst, trading can be no different than casino gambling...and when we're impatient, bored and looking for action, it's much easier to just go with our gut than to follow a disciplined plan. But it's this dangerous mindset that prompts us to put on a few thousand QQQs (QQQ) "for fun," or buy a random penny stock as a "lottery ticket." Neither strategy tends to be a high probability trade.

Probably the most frequent reason we trade from our gut is that we get angry. When we're upset with our spouse, our boss, our parents or our kids, we often avoid dealing with the issue directly and instead take our frustrations out on the market, opting for instinct over proper technique. Or when we lose money (as everybody does at some point) and haven't had a win in weeks, we toss discipline aside and trade from the gut. In my experience, both tend to be frighteningly expensive.

What, then, is an effective technique for minimizing the impulse to trade from the gut? Because instinct is driven most by emotion and outside influence, I do my darndest to eliminate both. How do I do it? Simply put: Don't ask, don't tell.

Don't ask! Once I've made up my mind and take a position, I systematically try and avoid reading any commentary or analysis about that particular security. Oftentimes it literally involves turning off the television or skipping magazine articles that discuss the company's prospects. Because what matters is the market, not the commentary, and once a position is taken, it's only my risk-control procedure that determines when it's time to exit a trade. Despite the need to "do your homework," when it comes to research, there can indeed be too much of a good thing. If you don't want to trade based on outside influence, steer clear of it altogether.

Don't tell! When it comes to investments, it's easy to become emotionally attached. The more I talk to others about my positions, the more I feel compelled to stay with them — even when it's probably time to move on. But when I've written about or pontificated on the merits of XYZ, it's not just the market I've got to contend with, but also my pride. In private, it's relatively easy to admit I'm wrong. In public, however, my ego is more likely to get in the way. So instead of talking about the market, I try to focus on watching it.

As with most aspects of investing, however, that's usually far easier said than done.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC