Perseid Macro - Trading Traps, Part 1: Pretending It Can Be Safe

Perseid Macro

One small player trying to make sense of the game

Trading Traps, Part 1: Pretending It Can Be Safe

A conversation I had as part of the Macro Ops community, spawned this series.

We all know that “the market” isn’t a sentient being with any sort of will. But it seems to act like a patient trapper. It’s not stalking us like a predator. The terrain is dangerous for us to walk through, and the market just waits for us to take a bad step.

When I was a kid, I remember learning about various traps people used, and one concept really stood out to me: “the animal makes the trap”.

The idea is that traps work by exploiting the nature of the animal being targeted. What could be a virtually inescapable trap for one animal would be completely harmless to another.

My favorite example of this is the raccoon trap (or at least the Davey Crocket-era myth of the raccoon trap I was passed down). Raccoons are notoriously compelled to collect shiny objects. To trap one, you put a small, sparkly object in a hole just bigger than a raccoon’s paw—like a knot in a tree. It will reach in and grab the item (making a fist that is now too big to fit through the hole). The raccoon could escape at any time by just letting go—but absolutely cannot overcome the compulsion to get that sparkly little object.

The trap isn’t the hole or the sparkly object. It’s the combination of the hole, the sparkly object, and the raccoon’s compulsive behavior. So, the animal actually brings the keystone of the trap to the situation: it’s behavior of relentlessly seeking out shiny objects. The trap is harmless without this keystone behavior.

In the same way, we bring the keystone behaviors to the traps we find ourselves in. Of course, our behavior is bit more diverse than that of raccoons. What is a deadly trap to some traders is nothing but silly hole with a sparkly bauble to others. But when a market trap catches us, it’s because of who we are and what we are compelled to do.

In this series, I’m going to try to explore some of these traps and their keystone behaviors.

On to the first trap!

Trap #1: Pretending It Can Be Safe

Trap #1 is straightforward, but very effective: people want to pretend that investing can be safe. This may seem obvious to any experienced investor (yet many seem to get caught up in it, after a series of wins). And there’s a variant of this trap that goes even further into our subconcious and is far more pervasive: the idea that investing can be made safe.

For example, when I first read about the new fiduciary rule, requiring that financial advisors have to “put their clients interests before theirs”, I thought—well, duh, that’s obvious! Shouldn’t it have always been that way? We all know there are so many scammers in finance. How could the government have been so slow in protecting people from that?

As I read more about it, I realized that “acting in your clients’ interest” actually meant “do what won’t get you sued”. If I’m a talented financial advisor, who can actually time the market or pick the best stocks, I can’t do that for my clients anymore. My picks will look different from the market portfolio. Any time that my picks underperform the low-cost index-fund du jour, I’m opening myself up to liability. I’ll be asked—purely after the fact and with all the nastiest cherry picking of returns—why I was screwing my clients. Was it for the fees?

Anyone who’s studied even a little bit of financial history knows that a strategy might be great, but it’ll stop being great as soon as everyone’s doing it. The sheer crowding of the trade ruins the returns and adds to the risk that everyone will try to exit at the same time, only to find no one on the other side of the trade.

This means that “protecting people from scammers” actually means forcing them all into the same trade(s). Sure it protects some unknown percentage of people from losing a percentage of their net worth to charlatans, but it basically guarantees that—eventually—a very large percentage of people will lose a very large percentage of their net worth to systemic risk.

Investing Can Never Be Safe

I was talking this through with a friend when this really triggered for me. The entire logic behind the regulation represents a whole class of traps. Investing can never be safe. It’s not supposed to be safe—it’s accepting risk for return. In fact, the greatest harm anyone can do to an investor is convince them that investing is safe. No matter how well-meaning their intentions are, the would-be protectors are trap-layers on behalf of the market.

It doesn’t matter what the risk is: scammers, bad risk-reward trades, liquidity crises. When we try to make it “safer”, we’re actually just pushing the bad experiences further away in time and making it easier for people to make large mistakes. Not everyone will fall for this, but the illusion of safety makes it easier—and the illusion gets more powerful the longer it lasts. It doesn’t matter what anyone does to try to “protect” us. They can’t change the fact that any sense of “safety” is an illusion.

Plus, most things that you do to make people “safer” will have secondary effects that will, over time, probably have the exact opposite effect. It’ll cause crowding, complacency, or excessive risk taking. Of course, there are some things worth doing: laws to prevent fraudulent financials, insider trading, front-running, straight-up stock price manipulation…But like so many things, these safety nets are subject to diminishing returns. Once you’ve solved for the most egregious abuses, you really do start need worrying that each additional precaution may do more harm than good.

Creating long spans of “safety” are the perfect way to catch the most people off-guard. But this trap only works on those who can be made to forget where they are and what they’re doing. If that’s you, then this trap was made for you.

So What?

There are 3 major reasons that I remind myself of this trap, even though it may seem obvious:

  1. So I don’t fall into it
    • Even with experience, I’m sure a good span of winners will make me vulnerable
  2. So I can exploit it
    • Supposed “safety” causes people to all behave in the same way—there will definitely be times when the right thing to do is take the opposite side of that trade
  3. So I don’t become a propagator of the trap
    • The last thing I want to do is push my friends and family into it

In a Perfect World…

If we invert the thinking, the only way to really make investing safer is to make each and every investor a better risk manager. The ONLY thing that can protect them—beyond the minimal antifraud regulations—is their own judgement.

Taking many small losses (whether due to bad investments, scamming, or bad luck) actually makes investors safer by improving their judgement. In a perfect world, the market wouldn’t avoid hurting people. It would nudge them as soon as they started doing something stupid. People need (hopefully small) reminders: Investing is dangerous. You might be wrong. People cheat. Be careful.

Just like wildfires, many small burns prevent the single, devastating blaze. Ideally, everyone would lose right at the start of their career and suffer small blindsides (that don’t blow them up) at regular intervals.

Most people, when they think of making investing safer, think about protecting newbies from bad experiences. I think this is exactly the wrong way to go about it. A real investing training program needs to do the exact opposite: encourage us (or at least free us) to encounter painful experiences, but without taking permanent damage. We need to experience setbacks—not blowups.

If you ever find yourself as a coach, advisor or regulator, you need to take responsibility for both 1) protecting people and 2) helping people develop their own judgement. The question has to be “How can we help new participants get stronger without dying?” That’s a framework that supports individual growth.

Yet, in my experience, almost all discussions regarding “safety” seem to turn into “We have to protect people from <some very bad thing> because it’s uncomfortable.” As if a well-enough designed system can make an unseeing, unthinking fool safe in the markets, on the street, or anywhere.

No government agencies, no reporting standards, and no experts can make investing safe. Instead of hiding under someone else’s protection, we have to constantly remind ourselves we are in danger. (And hopefully, we don’t let our good intentions lead us to direct others into this trap either.)

DISCLAIMER: None of this intended as investment advice. This is a place for me to put down my ideas and share them with others, whom I fully expect will tear these ideas apart. I have no professional training or certifications, and I've probably already changed my mind on whatever you just read.