AT THE CLOSE
Point (T) On The Laffer Curve
When is it too soon or too late? How much is too much or not enough?
Some of the most important questions that a trader must address have to do with getting the timing and the amount just right. There is an art to finding the right balance in life between too early and too late, and between too little and too much. For a trader, finding the right point to enter and exit a trade is critical to making money and limiting loss. Exercising the right amount of risk is also critical. Too much risk brings the possibility of losing too much money to keep you in the game. Taking on too little risk means that you will severely limit the amount of money you can make as a trader. So how do you find that point of balance?
Point (T) on the Laffer curve
If you have studied economics, you are probably familiar with the Laffer curve. For everyone else, the Laffer curve shows the relationship between taxes and tax revenue. As tax rates increase from low levels, people work harder and the government collects more taxes, but after a certain point (T), as tax rates continue to increase, people stop working harder and the revenues drop off. So governments want to find that point on the curve that simultaneously maximizes effort and tax receipts.
Note that this point is on a curve. It would be easy if that point of optimization were exactly in the middle of a nice straight line, but that is not how it works. If you plot tax rates on one axis and revenues derived on the other, what you get is a half circle and not a straight line, because the results rise and then fall, so the optimum point (T) falls somewhere along that arc.
Many if not most human endeavors have a point (T) as well. For example, successful parenting usually means that you have found that optimal point between being strict and indulgent. If you give your children too much, they become demanding, lazy, unmotivated, and unappreciative. But if you go too far in the other direction, you create rebellion, destructive behavior, low self-esteem, and resentment. Neither extreme produces children with whom you want to spend time or who will grow into self-sufficient, responsible adults.
Other examples:
- Employee compensation: Too little and they are not motivated to be productive, have a tendency to steal and sabotage, and you must spend time and money to replace them; too much and you cannot afford to stay in business.
- Exercise: Too little and you gain weight and become physically unfit; but too much and you risk injury and exhaustion.
- Hard work: Too little and you have lots of spare time but a serious lack of means; too much hard work and you have no life.
- Savings: A society that spends every penny and saves nothing will eventually fall into debt without the credit to borrow when needed, with a crumbling infrastructure and an inflationary economy; but a society that saves every penny and spends nothing will stifle demand for its own production, will likewise destroy its infrastructure, and will fall into stagnation and a deflationary economy.
Finding the golden mean
How do you recognize when you are at the optimal point in your quest to reach your goals and/or when you are too close to one of the extremes? In my experience, this is a difficult issue for most people to address because they come into a situation with a set of issues, values, and preconceived perceptions that act as filters. These filters make it difficult for most people to objectively measure the true effects of their actions. For example:
- Comfort zone filters: If you ask a trader if the level of the risk he assumes is the optimal level for his trading, he will invariably say yes, regardless of his results. The reason for this is that most people assume a specific level of risk, not because it optimizes results, but because it falls within the area of their comfort zone.
If, however, a trader is given the needed support to expand his comfort zone commensurate with his trading skills, he often discovers that his trading leaps into a higher level of profit. The reverse is true as well. If a trader who assumes too much risk deals with his need for the psychological and physiological stimulation he gets from risky behavior, he soon discovers that his profits, too, increase. - Modeling filters: If you ask a parent if he is exercising sufficient parental controls to keep his teenager out of trouble, he will often tell you yes, regardless of his child’s behavior. The optimum point for a parent to exercise limits on behavior is likely to be based on his or her own upbringing, and he will be modeling on what he has experienced himself or on what he has seen, rather than on what is effective parenting. The same principle can apply to traders who exercise self-discipline in the conduct of their trading.
If a trader was raised in an environment of extreme self-indulgence on the one hand or extreme self-denial and self-discipline on the other, he may be modeling a pattern of extreme behavior without being able to see its long-term consequences. Asking him to moderate his extreme behavior in order to maximize results will likely bring about little or no change because he is unaware of what he is doing. - Emotional filters: The level of effort a trader expends in reaching his goals may also be extreme. I have worked with traders who spend 20 hours a day, seven days a week, at their research and trading. It is difficult to get these traders to cut back on this extreme behavior in order to maximize their results because they are often motivated by emotional and psychological reasons. A trader who feels fear or guilt or inadequacy may be driven to compensate by working to the extreme. His emotional needs act as a filter so he is not able to see the correlation between his effort and his results.
If a trader who is being propelled by unresolved emotional issues acknowledges these issues and resolves them, he often discovers that he no longer has to work at a backbreaking pace in order to succeed. In fact, he usually finds that the increase in physical and emotional energy he derives from cutting back his hours allows him to increase his focus and, thereby, his profits. - Values filters: Money management, for example, extends beyond the issues of risk for a trader. The way in which he manages his money once he earns it will also determine his level of success in trading. If he spends his money as fast as he makes it and does not put any into savings, he is not providing for himself and his family for the possibility that he might need a cushion of safety. Spending at an unreasonably high level puts him under greater pressure in his trading and may be the cause of risky and unsuccessful trading. So what can be the cause of this kind of nonoptimal behavior?
I have worked with traders who come from a family or cultural influence that measures an individual’s worth by his material displays of success. Rather than being able to figure out what is appropriate spending and money management, a trader raised in this value system may not be able to make a well-reasoned decision about what level of spending is optimal for him and his family. Instead, societal and family pressures will prevail.
Eyeballing it
The fastest way to tell if you are not even close to the optimal point (T) toward meeting your goals and that your means are not working for you is by asking yourself a series of questions:
- How close am I toward achieving my goals?
- Are there certain areas of my performance or my life that are creating disharmony?
- If I continue to do what I’m doing, will my efforts eventually result in success?
- If I were to intensify my efforts in doing what I’m doing, will I improve the outcome?
- Are the people I know who are successful in the area I want to be successful in doing the same things I am doing to achieve their success?
- Do I get feedback from the people in my life (which I generally ignore) that I am doing something in the extreme (such as I am working too much, taking too much risk, getting too upset or stressed, spending too much money, drinking or doing anything else too much)?
In other words, the fastest way to acknowledge that you are not at point (T) is to look at your success. You must measure your success on two levels: first, the quantitative level (how much money are you making?) and second, the qualitative level (how much effort are you expending and how happy are you in the process?).
Modeling Laffer
So if our own perceptions prevent us from seeing what the right point is for optimal result, how can we find it? Just like the optimum point (T) on the Laffer curve is derived from plotting data on a graph, finding the optimal point for any set of activities required to reach a goal can be found through keeping track of results and plotting them.
Suppose you are interested in finding the optimal level of risk you need to be taking in order to create profits from your trading. If you assigned a number value to the level of risk from one to 10 and then kept careful records of the profits you gained from your trading and plotted them on a graph (with risk on the x-axis and profits on the y-axis), you would find that you created an arc graph that starts toward the bottom of the left side of your graph, rises to its highest point, and falls off toward the bottom again at the right side of your graph.
If you find the highest point on the arc, you will find the point of maximum profits at the minimum riskpoint (T). The arc may not be a smooth or symmetrical half circle, but that doesn’t matter. The objective is to find that point of maximization of effort versus results.
The point of this exercise is to demonstrate the fact that point (T), that optimal point, is not immediately obvious to us because of our preconceived positions on the subject. Only through objective measurement can we find it.
Another example would be to objectively measure your profits versus the number of hours you work a week. Again, the answer may be a surprise to you. In fact, you might find that you need to increase your hours! Or you might find that your trader’s coach was right – you will make more money when you decrease your hours to only two trading hours a day. But the results for each trader are different, so you cannot extrapolate another trader’s experience for your own.
Putting balance back into the system
One of the key factors in finding point (T) in your life is the fact that objectivity, when it comes to your own life, may not be within your reach without enlisting outside help. Traders who play at the extremes of the continuum most often have unresolved issues in their lives that need to be addressed. They may have set goals, developed well-thought-out plans with contingencies, and worked diligently to put them in place, only to be sabotaged by their own unconscious motivations. This is where a trained professional can bring balance to a trader’s life.
One of the first things I do with a trader who wants to work with me is to ask him to fill out a trader evaluation. This self-assessment is designed to uncover strengths as well as distortions, inconsistencies, and patterns of self-sabotage in a trader’s performance as evidenced by his perceptions, attitudes, goals, values, and outcomes.
Are you at point (T)?
If you have come to the conclusion that you need to find the point (T) in any particular area of your life, you may want to find out what forces in your life and in your own psychology are pushing you to the extreme position. Is it a question of your own fears and insecurities or of a need to conform to the expectations of others? Does the thought of changing your approach make you feel uncomfortable or threatened? Are you getting feedback from your trading and from those around you that you are far from the optimal point (T) in your approach to reaching your goals?
If so, you can conduct your own test to see where that optimal point would be. Along the way, you can also enlist the support of people trained to help you reach that point of balance. Whichever means you use to find point (T), the first step is in acknowledging the fact that point (T) exists for each trader, and it is different for each trader – and once you find it and are able to reach it, you will have found your own personal holy grail.
Adrienne Toghraie is founder and head of both Trading on Target and Enriching Life Seminars.
She may be reached at www.tradingontarget.com.