1. Rationality. It is critical to be able to objectively analyse markets, reality, businesses, your own failings, your performance, using reason rather than emotion. It is also critical to be able to make decisions on the facts, and not be affected by how much money you made or lost recently. The ideal speculator would trade identically after making $1 million as he or she would after losing $1 million. Most people are way too emotional to be able to speculate successfully.
2. Pattern recognition. In my view, markets follow certain patterns, which generate predictability and thus inefficiency that can be exploited. I believe that these come from flaws in human psychology. People who detect patterns quicker, better, and more deeply than the norm, will pick up these inefficiencies faster than the rest. I think there is some artistry in recognising patterns – and this tends to handicap people who lack some artistic and creative talents. For example, engineers, doctors, and dentists are infamous for being poor speculators. If you are good at pattern-recognition games like chess, poker, backgammon, go etc, then there’s a good chance you have some of the traits needed to speculate.
3. Independent thought. Some of the most profitable speculations come from taking the opposite side to a dominant consensus; and some of the worst losses come from accepting conventional wisdom, or following the popular stocks and markets of the day. It is therefore absolutely critical to be able to think independently, and divorce your views from that of the crowd. Note that ‘the crowd’ is not necessarily the retail investor – often the crowd is most hedge funds and professional investors. If you are the sort of person who goes along with the majority, or is uncomfortable telling almost everyone that they are totally wrong and misguided, you are unlikely to be a good speculator. A speculator needs to be something of an iconoclast, maybe even a bit of a misanthrope.
4. Passion for studying the markets. It’s rare to succeed at something you don’t have a strong interest in. Markets, perhaps more than any other field, reward historical study – the same themes play out repeatedly, but over long periods of time, so superficial research (e.g. looking at US stock market behaviour for the last 30 years) often fails, where more in-depth study (such as researching the panic of 1907, the great silver bubble of the 1970s, or extreme boom/bust processes in obscure 3rd world markets) pays greater dividends. Good speculators know their market history.
5. Market experience. Speculation is a field where experience really counts – not just in time, but in variety and depth. The more market environments you have participated in, the more familiarity you get with how markets work – reading about the crash of 1987, or the dot-com bubble, is just not the same as actually living through it and trying to trade during such wild environments (although reading about something is better than not doing anything at all). There is a reason most great speculators don’t really get going until their 30s, and often hit their prime in their 40s and 50s. George Soros started his fund at 39, Julian Robertson in his early 40s, and Buffett made his biggest gains in the 70s through the 90s, for example.
6. Discipline and work ethic. My weak point. Markets are a tough game and the competition is fierce – the more time you put in, the better you will do. Personally I enjoy life a bit too much to be a workaholic, so I will probably not reach the top of my field – but it can be profitable, and more fun, to make a satisfactory living with a reasonable effort.
7. Contingency planning. Markets are a complex and hard-to-predict open system, a bit like wars in that respect. It is not enough to simply study the evidence, then form a view and hope that it is right. The skill comes not so much in handling cases where you are right (although that is important), but in handling situations where you are not sure, or where you might even be plain wrong. Minimising losses when you are wrong is critical. So is designing trading plans that can profit in multiple market scenarios, where other traders hold back because things aren’t clear (by the time things are clear, usually a lot of the profit potential has disappeared.). A good speculator, like a good general, prepares for all plausible eventualities – and even some implausible ones.
8. Patience. Speculation is a field where you don’t have to play unless the odds are strongly in your favour. If you are adequately capitalised and live below your means, the cost to waiting is low. Whereas the cost of making a bad trade is very high. So, you must remain patient and not take risks until opportunities come along that are so attractive that they justify the risk of losing money.
9. Risk control. A good speculator thinks like Andy Grove – only the paranoid survive. Good speculators are always thinking what can go wrong with a trade, with a portfolio, even with the markets or life. A great example is from Nassim Taleb’s early writings – he talked about a French risk manager at his bank who went through his trading positions, and asked Taleb what was his risk control plan if a plane crashed into the building. When I told this anecdote to friends pre-2001, they all laughed – I didn’t, and neither did any other good trader I told it to, rather we all thought “hmm good point” and started (if we hadn’t already) planning our response if something like a natural disaster, political assassination, terrorist attack, or war broke out. Furthermore, it is not enough to analyse rare event risks, you must also make sure that your ‘normal’ risk-taking is within certain limits. If you are right, but your risk is too big, you can suffer catastrophic losses that take you out of the game before you can profit – you may be right but still go bust. Good speculators control and limit both normal market risk, and so-called “Black Swan” risk.
10. Seeing the big picture. A good speculator is always seeking the connections between seemingly unconnected events. When Mount St. Helens erupted, an acquaintance of George Soros was surprised to see him trying to figure out what the impact would be on grain prices. But that’s what you must do as a speculator. People holding off buying iPhones in summer 2011 until the iPhone 4s comes out? Hmm, what impact might that have on Apple earnings? iPhone 4s now out on the market? Maybe next quarter will return to the familiar pattern of beating expectations. Civil war breaks out in the Ivory Coast? Better consider the implications for cocoa futures. Ditto for Orange Juice futures if a couple of hurricanes come close to the Florida coast during growing season after a multi-year bear market. Even the latest celebrity fad might result in a mini-boom in some obscure retail stock – a speculator should be promiscuous in their research into potential connections between society and the markets.
11. Decisiveness. Markets can move and change fast. It is critical to be able to act decisively when needed. There are many good analysts in the markets, but few of them are able to translate their analytical prowess into profitable speculation. Much of the reason for this is that they lack decisiveness, and tend to suffer ‘analysis paralysis’ or freeze when the pressure is on. Preparation and experience can help you to be more decisive, but ultimately you must have it in your nature to pull the trigger under stress situations. Someone with a gamer’s hair-trigger mentality will probably do better than a studious book-worm type who prefer to consider at length before making decisions.
12. Willingness to admit mistakes. Markets are an odds game. Even the best-prepared, highest conviction trade can be undermined by events. When you are wrong, often the price goes way further against you than you would expect, causing major losses. It is essential to put ego aside and be willing to not only admit mistakes, but also to immediately exit your position (and sometimes reverse). A good speculator can be maximum long one day, and then exit completely, get flat, and actually start shorting the same asset a few minutes or even seconds later, if he realises he was totally wrong. There is a good passage in one of Jack Schwager’s “Market Wizards” books, where Paul Tudor Jones is telling him about a time he was heavily long and then realised the market was going to collapse: Schwager said “so you knew you wanted to get flat” and Jones replied “No, I knew I wanted to get short”. That is the true speculator mentality – zero attachment to past opinions, positions, or core convictions, if the evidence changes on a dime.
So, these are the skills I think a good speculator needs: rationality, pattern recognition, independent thought, passion for studying the markets, market experience, discipline and work ethic, contingency planning, patience, risk control, seeing the big picture, decisiveness, and willingness to admit mistakes. You will notice that the list is dominated by abstract mental skills, and that most need either highly rational or creative and forward-looking thinking. If you are an original and creative but also very rational thinker, you may have what it takes to succeed as a speculator, should you wish to do so. Just remember that experience counts for more in this profession than most – for that reason, I feel it is better to start at a trading firm or under an experienced speculator (possibly as their trading assistant), than to go it alone from day 1. Study and observe the markets thoroughly and patiently, paper-trade, then graduate to trading small with minimal funds, and slowly scale up as your experience and results improve.