A Three-Legged Stool Approach to Trading

Apurva Sheth

A few days back, my colleague at Equitymaster, Rohan Pinto, Research Analyst, wrote an interesting piece on investing. In this article, he wrote about renowned value investor, Chuck Akre, who runs Akre Capital Management. Mr Akre is known for his ability to identify companies with great potential. He first invested in Berkshire Hathaway back in 1977.

Akre has a simple construct that will help you in your search for outstanding investments. It's known as the three-legged stool construct.

A company must be evaluated on three important aspects:

  1. Business model
  2. Management quality
  3. Reinvestment prospects
Three-Legged Stool Construct

If you can find a great business run by an ethical management that has the potential to reinvest its own capital, compounding takes over. Successful Investing over the long run is all about finding companies that can compound your wealth.

I love how simply the three-legged stool approach explains these cardinal rules for investing.

I have been reading an excellent book, Come into My Trading Room, by Dr Alexander Elder. Dr Elder is a professional trader and a practicing psychiatrist. His experience as a psychiatrist provides him with unique insight in to the psychology of trading. In his book, Dr Elder also uses a kind of three-legged stool approach. He calls it the three 'M's of successful trading:

  1. Mind
  2. Method
  3. Money

Mind is your trading psychology. To be a successful trader, you have to develop iron discipline in multiple fields and always maintain the right frame of mind. Choosing which battle to fight and which ones to avoid requires discipline.

A successful trader is always humble. He is self-assured but never arrogant.

A trader must draw a clear line between a businessman's risk and a loss. A businessman's risk is a small dip in the trading capital. A loss goes through that limit. It is much higher than businessman's risk. A trader is in the business of trading and can take normal business risks but he cannot afford major losses.

A disciplined trader takes his losses without hesitation. He exits trades without fail when his stops are hit. A disciplined trader never lets the voice of a broker influence his decision.

A mindful trader keeps good records. He maintains a trading journal not just for his accountant but as a tool of learning and discipline. Maintaining a trading journal helps you improve your performance, rate your progress, and learn from mistakes.

Method is how you go about finding trades and making entry and exit decisions. It is a system of analysing prices and developing a decision-making tree. A successful trader is aware of the various types of trading strategies (momentum and countertrend) and knows which one suits his style of trading. He has a plan ready before entering a trade and knows what to do before, during, and after a trade.

He knows what markets to trade (equities, currencies, commodities) and also has thorough knowledge of the instruments available (stocks, futures, options) to trade in those markets.

Financial markets are run by two parties, bulls and bears, buyers and sellers. Bulls push prices up. Bears push them down. A successful trader develops a method to identify which camp is overpowering the other. Technical analysis helps to identify which side is stronger than the other. Traders can use technical analysis to look for repetitive price patterns, to recognise uptrends or downtrends, and generate buy or sell signals.

Traders can use various tools like trendlines, channels, supports and resistance, moving averages and momentum indicators to identify these trends at an early stage to benefit from them.

Money is how you manage you trading capital for long-term survival and success. It is the craft of managing your trading capital. The goal of money management is to accumulate equity by reducing losses on losing trades and maximising gains on winning trades. It is easy for one to make money on a single or a few trades, but it is very difficult to grow equity. The slope of your equity curve is the ultimate test of your mind and method. It reflects the state of your mind and quality of your methods.

A trader limits his losses on any trade to 2% of his equity capital. He does not risk not more than 2% of his capital on any single trade. This ensures that a single trade does not make or break his account. He has enough chances to come back in the markets even after running a losing streak.

A trader stops trading whenever the value of his trading account dips 6% below its previous month's value. He may close out all his open positions and sit on the sidelines for rest of the month. During this period, he may continue to analyse the markets but should also review his system and identify problem areas and work on them.

The 2% rule saves a trader from a disastrous loss while the 6% rule saves him from a series of losses.

If you can apply the three 'M's, I am confident you'd see a remarkable improvement in your trading performance. But unfortunately, most retail traders fail to do so. The majority of them focus on the second 'M' - Markets - and only with respect to entries.

Retail traders always want to know the next big trade. They're always on the lookout for entries into to new stocks. They rarely focus on exits. Most of them are not even aware of the other two 'M's - Mind and Money. Trading without them is like trying to sit on a stool with missing legs.

All three legs - Mind, Market, and Money - are equally important. At Swing Trader, we have known this from day one and always strive to balance our recommendations on all three legs.

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What is your three-legged stool approach to trading? Share your views in the Club or share your comments here.

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2 Responses to "A Three-Legged Stool Approach to Trading"
J.Dayah
08 Nov, 2016
I was impressed with Apurav Sheth article on Swing Trading article. Personally Iam not day trader but liked his technical analysis. Like 
santhanam
02 Nov, 2016
Three legged stools super guidanceLike (2)
We request your view! Post a comment on "A Three-Legged Stool Approach to Trading". Click here!