What is the single most important factor in successful trading? It takes a lot to be successful at trading over the long term, but obviously some factors are more important than others. Is it enough to just have a large bankroll? What about careful asset allocation - will that ensure success? Is consistent execution of your strategy the key? Or, as so many traders seem to think, is the most important factor simply finding a winning trading strategy?

In part one of this article, we propose a thought experiment for getting clear on exactly which factor(s) are most important for successful trading.

The Veil of Ignorance

Imagine that you’ve just decided to become a trader.  Trading is now going to become a big part of your life, and you want to make a stable and worthwhile income from trading. But in this thought experiment, you’re behind a “veil of ignorance” (with apologies to John Rawls) and you don’t know very much about yourself. You don’t know how much prior experience you have, you don’t know whether you’re familiar with any particular trading strategies (breakouts, momentum, volatility, time decay, etc.) or instruments (stocks, bonds, options, forex, etc.), and you’re not even sure how much trading capital you have to start with. Later on in this story, you will step out from behind this Trader’s Veil of Ignorance, and you might discover that you’re a senior strategist at a prominent mutual fund. You might find out that you’re a hardened solo cowboy at a New York proprietary trading desk. Maybe you’re a hyperactive floor trader at the CBOE in Chicago. Or maybe you’re just another starry-eyed newbie coming out of your first “free” trading seminar in a dank hotel conference room in Topeka. You might be any of these people, or someone else - you just don’t know.

Now, imagine that a wise old market maker comes along and decides to offer you an incredible gift.  Although he can’t tell you anything about who you really are (you’re still stuck behind the veil), he will offer you a choice of one of four possible gifts. Once you make your choice, he will grant that wish and you will step outside the veil and begin your trading career. Your choices are:

1. Capital - although you don’t know exactly how much you’re already starting with, you know it is more than $10,000 and is less than $1,000,000.   In other words, you know you’re going to have enough money to fund an account and get started. If you choose capital, the wise old market maker will magically double the size of your trading capital, however much that is.
2. Asset Allocation - although asset allocation is extremely important, most new traders (and even a lot of experienced traders) never learn proper methods for managing risk and allocating their capital. This leads to larger than normal drawdowns and even total wipeouts. If you choose asset allocation as your gift, you will instantly learn all you need to know about proper risk management and portfolio allocation, and more importantly, you will never make mistakes like putting on dramatically oversized positions or under-diversifying, etc. In essence, you will become instantly experienced at keeping your positions in good order and keeping your capital spread out across an appropriate number of positions.
3. Winning strategy - Picking stocks at random doesn’t work very well. Market timing based on what people write on message boards doesn’t work very well, either.   There are a zillion technical indicators and breakout systems and other strategies out there, all with varying levels of success. In fact, some traders spend far more time constantly searching for winning trading strategies than they do actually trading. If you choose a winning strategy as your gift, you will receive a trading strategy that has a proven track record, has a rational and statistically significant probability of future success, can be explained in strictly rational and analyzable terms, and is simple enough to be useful for or at least learnable by any average retail trader. You can choose to get all the detailed nuts and bolts that explain the strategy, or if you want you can get it as a “black box” that spits out signals; either way, you’re guaranteed a strategy that doesn’t have a perfect win/loss ratio (no strategy ever does) but is nevertheless going to make you money over time.
4. Consistent Execution - Everybody knows that making trading decisions based on emotions is a recipe for disaster, and we all try to keep our emotions in check. But even on our best days, sometimes we second-guess our strategy, or we become overly risk averse and opt out of reasonable trades, or we become exuberant and let winners turn into losers. After a series of bad losses, sometimes it’s tempting to pack it all in and take up golf instead. If you choose consistent execution as your gift, you will be able to execute the trades dictated by your strategy - whatever it is - and you will stick with your strategy. When times are good and you feel like a genius, you won’t enter trades that aren’t dictated by your strategy just because you have a hunch, and when times are bad, you won’t give up and run just because you’re afraid or panicked. While your execution may not be perfect, this component ensures that you won’t make any of those common execution mistakes that plague so many ordinary traders.

After the wise old market maker presents these four possibilities, you think for a minute, and then make your choice. You step out from behind the veil, and suddenly you’re aware of all of the things you didn’t know before - how much experience you have, how much capital, and how much knowledge about strategy, risk, etc. Plus now you have one of those four components of your system wholly covered. You sit down at your computer, and the opening bell rings. What did you chose?

We’ll tell you what we chose in Part 2.