This post follows on from How is it Possible to Understand the Market? (1).

What are the combinations of personal and theoretical knowledge that one finds among market participants?

1. Poor personal knowledge: This describes both the cynic and many unsuccessful traders. They have tried to get to know the market and have either proved incapable of achieving a sufficiently different personal understanding from the one they use to understand other people, or have not yet reached personal understanding.

2. Good personal knowledge: Successful day-traders may fit into this category. After years living with price, volume and newsflow, they have come to understand the market well enough to make money on average. A systematic trader who has found a method that works, but does not know why it works, also fits in here. They are likely to struggle if market conditions change significantly (for example, those raised in bull markets may struggle in bear markets).

3. Personal familiarity and a theoretical toolkit: Some (not all!) asset allocators and brokers are my model for this category. A person can thrive in either job without making money from tactical trades or stock picks on average. They will be comfortable with the behaviour of the markets, having been around them for many years, and will have a toolkit of theoretical concepts that have been used to understand the markets. They will pick concepts from the toolkit to support their latest market views. Essentially, people with type 3 understanding do well by aping the behaviour of people with real personal and theoretical understanding.

4. Personal knowledge and implicit theory: I have met fund managers that fall into this category. A person can be a good fund manager because he has a good feel for the behaviour of stocks, say, or the behaviour of markets after data releases, and a consistent methodology that makes money on average. He will not necessarily have, and indeed does not need to have, an explicit understanding of the theory embodied in his methodology. The training of equity analysts in established valuation methods may lead them to be type 4 (for this reason I used to ask fund managers to describe the intellectual journey that had brought them to their way of doing things, rather than asking them to lay out the theoretical underpinning of their methods). Poor fund managers may be type 3.

5. Pure theory: This is the realm of the systematic trader who thinks he understands why his trading method works.

6. Personal knowledge and explicit theory: It is tempting to assume that this is nirvana for the discretionary trader. I have often read that the best traders are the ones who have developed their own theory of the markets. One objection to this idea is that it is important that the theory is at least partially true; another is that the theory does not have to be one’s own, as long as it is deeply understood. Further, it may be that the requisite personal knowledge for a trader on my time scale — with a holding period of weeks to months — is entirely negative (i.e. it is about learning what not to believe — “this market has gone far enough,” “buy the dips,” “you can’t go broke taking profits,” etc.), or there may be a lot more to it. In other words, knowing how to achieve nirvana is not as easy as it sounds. I hope to develop this in some further posts.

Going out on my own as a trader was really about trying to make the transition from type 3 to type 6.