In general, I find there are two kinds of traders. The first kind trades visually, from patterns that are evident on visual inspection. Those include chart patterns, oscillator patterns, Elliott waves, and the like. Their trading decisions are discretionary, in that they elect to buy, hold, and sell based upon their perception of patterns and their judgment as to their meaning.
The second kind of trader distrusts visual inspection. Such traders are more likely to buy into the behavioral finance notion that unaided human perception and judgment are subject to a variety of biases. Accordingly, these traders use some form of historical/statistical analysis and/or system development to test ideas and trade only those that test out in a promising way.
Now here’s the interesting part: The first group of traders almost universally asks me to help them tame their emotions. They have problems with impulsive trading, failing to honor risk limits, failing to take valid signals due to anxiety, etc. The second group of traders, having researched successful strategies, almost universally asks me to help them take maximum advantage of their edge. They want help taking *more* risk and trading larger positions. (more…)
Archives of “biases” tag
rssManaging Risk
Over the years I’ve been fortunate enough to get to know thousands of market participants. Some are long-term investors others are scalping pennies per trade on thousands of shares while others manage millions of other people’s money. The interesting theme I picked up on with nearly every one of them is that they each experienced panic and uncertainty at certain times in the market. Oftentimes, this panic stems from the inability to make sense of the market, to gain control of market participation. Thoughts such as whether or not too much capital is at work or perhaps not enough or even whether or not to be in the market at all seemed to consume them.
This ambivalence can consume and debilitate even the best market participants. The uncertainty or self-doubt about market participation is common yet finding a solution is not. The greater the level of uncertainty felt the higher the odds are that risk is being misperceived. Here are some questions that I’ve asked to assess whether risk was real or perceived:
- What are your reactions, both physical and emotional, to a losing trade? A winning trade?
- Have you rationalized recent losses?
- Has your out-of-market homework/research fallen behind?
- Do you monitor your positions by dollars or percentages?
- Have you ever not taken a trade that made sense simply because you were burned before?
- Has the number of indicators you use to enter/manage/exit a position increased/decreased lately?
- Do you know the Beta of your portfolio?
- What would others say about you when asked about your risk management?
In a sense, managing risk involves managing the emotional side of trading so that the focus can be on the cognitive side of trading. As an example, if I’m concerned with the direction of the market because my traditional analysis methods are giving unclear signals then it probably doesn’t make much sense for me to participate. My biases will impact the data, whether it’s of a technical or fundamental nature, and lead to poor decisions. If I’m unable to clearly define what sectors are leading and which are lagging and, more importantly, why they are moving in the direction they are, then my risk is skewed. It’s times like these that large losses can accrue as objectivity is clouded by subjectivity.
I’ve always used sleep as a gauge to help me know if I’m in-line with real risk. If I’m able to sleep at night and wake up excited to participate in the market then I know that the odds are good I’m managing my risk. If I’m unable to get a good night’s sleep and lay awake wondering about positions I have on the odds are good that my risk management is off. Yea, I’m pretty simple.
10 Most Common Behavioral Biases
I offer my list of Investors’ 10 Most Common Behavioral Biases. There are a number of others, of course, and more will continue to be uncovered. But I think that these are the key ones. Your suggestions of important ones I have missed are welcome.
- Confirmation Bias. We like to think that we carefully gather and evaluate facts and data before coming to a conclusion. But we don’t. Instead, we tend to suffer from confirmation bias and thus reach a conclusion first. Only thereafter do we gather facts and see those facts in such a way as to support our pre-conceived conclusions. When a conclusion fits with our desired narrative, so much the better, because narratives are crucial to how we make sense of reality.
- Optimism Bias. This is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy. Indeed, we live in an overconfident, Lake Wobegon world (“where all the women are strong, all the men are good-looking, and all the children are above average”). We are only correct about 80% of the time when we are “99% sure.” Fully 94% of college professors believe they have above-average teaching skills (anyone who has gone to college will no doubt disagree with that). Since80% of drivers say that their driving skills are above average, I guess none of them drive on the freeway when I do. While 70% of high school students claim to have above-average leadership skills, only 2% say they are below average, no doubt taught by above average math teachers. In a truly terrifying survey result, 92% students said they were of good character and 79% said that their character was better than most people even though 27% of those same students admitted stealing from a store within the prior year and 60% said they had cheated on an exam. Venture capitalists are wildly overconfident in their estimations of how likely their potential ventures are either to succeed or fail. In a finding that pretty well sums things up, 85-90% of people think that the future will be more pleasant and less painful for them than for the average person.
- Loss Aversion. We are highly loss averse. Empirical estimates find that losses are felt between two and two-and-a-half as strongly as gains. Thus the disutility of losing $100 is at least twice the utility of gaining $100. Loss aversion favors inaction over action and the status quo over any alternatives. Therefore, when it comes time for us to act upon the facts and data we have gathered and the analysis we have undertaken about them, biases 2 and 3 – unjustified optimism and unreasonable risk aversion – conflict. As a consequence, we tend to make bold forecasts but timid choices. (more…)
HOW TO LOSE MONEY IN THE STOCK MARKET
There are so many ways to lose money in the stock market but whether it is from blindly trusting what turns out to be a Bernie Madoff ponzi scheme to refusing to take a loss on a “sure thing”, the root cause of losses is our inability to objectively perceive market action without the many and varied biases associated with “money on the line”.
According to Mark Douglas…
In any particular trade you never really know how far prices will travel from any given point. If you never really know where the market may stop, it is very easy to believe there are no limits to how much you can make on any given trade. From a psychological perspective this characteristic will allow you to indulge yourself in the illusion that each trade has the potential of fulfilling your wildest dream of financial independence. Based on the consistency of market participants and their potential to act as a force great enough to move prices in your direction, the possibility of having your dreams fulfilled may not even remotely exist. However, if you believe it does, then you will have the tendency to gather only the kind of market information that will confirm and reinforce your belief, all the while denying vital information that may be telling you the best opportunity may be in the opposite direction.
There are several psychological factors that go into being able to assess accurately the market’s potential for movement in any given direction. One of them is releasing yourself from the notion that each trade has the potential to fulfill all your dreams. At the very least this illusion will be a major obstacle keeping you from learning how to perceive market action from an objective perspective. Otherwise, if you continually filter market information in such a way as to confirm this belief, learning to be objective won’t be a concern because you probably won’t have any money left to trade with (italics mine).
From Chapter Four of THE DISCIPLINED TRADER
Bottom line: successful trading is about making money…not about being right.
Trend following..
The objective of the trend follower is to employ discipline to offset biases in order to extract signals from prices to the exclusion of other information. In fact, this has greater similarity to a statistical or engineering problem than to a finance problem. Because prices are surrounded by or filled with noise, trend following is a form of price smoothing. You eliminate the noise to obtain a clearer signal. It also can be thought of as a filtering problem. You throw out the excess information that may be associated with trades that are not driving the trend signal.
Remember These 13 Points
- Predictions do not work as tomorrow is uncertain. We will only boast about things we have predicted right and talk nothing about the other half we got wrong.
- Skills can bring us moderate success. However, luck is needed to be a big success. (credit to Jon)
- We tend to credit our successes to good skills and blame our failures on poor luck.
- Some of us rely on luck (most unknowingly) by investing for high returns (and losses). A few of us will make big money but most of us will end up much poorer.
- Some of us deliberately limit the luck factor by choosing investment products with capital guarantee and guaranteed returns. None of us will make big money but none of us will be very much poorer.
- We need to know how much we can afford to lose (financially and emotionally) before deciding to be No. 4 or No. 5, or somewhere in between.
- We have many biases. The degree of success in investing or trading depends on how much we can keep our biases in check. No, we cannot remove our biases totally.
- Confirmation bias – we see what we want to see. We seek out evidence to validate our investment decision and ignore those that suggest otherwise.
- Availability bias – we are influenced by the things we observe. If people we knew made a lot of money through property investment, we will think that properties are the best investments in the world and develop a preference for it.
- Loss aversion bias – we want to be compensated for high returns before we decide to take the risk to invest. We often wait for markets move and show high returns before we want to invest. We are not interested if markets are not moving.
- Hindsight bias – we tend to say “I knew it” after an event has happened.
- Survivor-ship bias – we only get to hear stories of successes but many stories of failures were untold. See No 2 and No 3.
- Most us do not know what we want in life. We think we will be happier with more money.
BELIEFS
What you believe, consciously or unconsciously, propels your trading in its many directions. It might be so simple a matter as whether you believe a market is going up or down or nowhere. Traders have biases that distort their perceptions and effect their actions, and they need to guard against these with various protections and bias detectors.
Other beliefs are more veiled and ubiquitous. For example, you may consciously intend to make money, but you have a counter impulse that thwarts you due to unconscious beliefs that go against that intention. Perhaps you unconsciously believe that money is the root of all evil, or that rich people are corrupt, or that there isn’t enough to go around and so you shouldn’t be greedy, or that you should be laying up your treasure in heaven, and not on this earth. Perhaps on some level you believe you shouldn’t make more money than your parents.
When you want something, you have to really want it and not be ambivalent about it. It has to be your desire, and not some alien value set by your parents or society. The flower loves the sun, and stretches to receive its rays. The plant loves water and digs its roots deep seeking the object of its desire. If you want to make money trading, you really have to admire money and have good purposes for its use. If you want to be a master trader, you have to be comfortable with that role, and not see trading as wasteful gambling, or an unworthy profession.
Perhaps you believe that you don’t deserve to make money trading, or that you have to work hard for your rewards. Maybe you believe that only the big boys win, that the market is stacked against the ordinary trader. Maybe you believe that it’s impossible to make money in the futures markets or, worse, any market. Maybe you believe it’s possible to make money trading, but it’s not probable that you can keep your winnings. All such ideas run in opposition to easy and effective trading.
Just as insidiously you may doubt that your system really works, or that it won’t work this time. Some traders get superstitious: for example, they believe that they always, or tend to, lose money on Fridays, and so, of course, they do. When any of their superstitious factors occur, somehow they manage to lose.
The 'Self-Factors' of Successful traders
- – Knowledge of oneself and how one acts and behaves in situations and environments.
- Self-Belief; – Self-Confidence – assuredness in one’s actions, judgments and abilities.
- Self-Trust; -The ability to have faith in oneself under duress and pressure.
- Self-Reliance; – Ability to depend on one’s own capabilities, judgment, and resources , and acceptance that nobody else is responsible for profits and losses.
- Self-discipline; – A structured approach that keeps a person focused and grounded against negative forces and pressures.
- Self-Control; – Is the ability of exert mind muscle and will-power to overcome the negative effects which can so easily distract and distort perceptions and judgments.
- Self-Motivation; – Describes the initiative to undertake risks and activities when the mood and environment have been counterproductive.
- Self-Esteem; – High regard, respect or value for one’s self, but not to the level of being conceited, or having an over-inflated opinion of their worth.
- Self-efficacy; – Belief in one’s own competency and ability.
In summary, successful traders take responsibility for their own actions, but rarely beat themselves up. – If I was to sum it up succinctly, they know themselves, they like themselves, they believe in themselves, and above all – ‘they are comfortable in their own skin’. (more…)
Patience
The most difficult thing for traders to do is to sit there and wait. Why? Because, we live in a world that is on a total dopamine, hypomanic binge. This is never more clearly manifest than by those who absolutely have to be in the markets at all times, desperately need to be trading and simply cannot wait. They are human do-ings, rather than human be-ings.
—
There is a wonderful advantage to waiting for the right entry and exit points. This allows you to be in a market- neutral mindset, and frees you from looking frantically for bearish or bullish views to justify your biases. Granted, you are not making money, but you are also (and much more importantly) not losing it. You are preserving capital. You can take time to reflect study, hone and refine your trading plan, adopt some healthy exercise and dietary habits, and become a stronger and more centered person. Simply waiting without stress for the right opportunity allows you to become a more rational and impartial observer.
Patience frees you from active involvement in the chaotic, and often reckless, behavior of others in the markets, and it puts you and your trading plan into a clearer perspective. It allows you to see yourself as a human be-ing, rather than a human do-ing.
When you first started trading, what did you hear constantly? Preserve your capital. You heard it, but maybe you did not listen, or did not understand. If you have no financial capital to use, you are out of the game. If you are chasing or getting in just to get in and are getting whipsawed daily; and you are losing, drip by drip, or in larger chunks, you are out of the game. If you are cutting your winners too quickly and letting your losers ride, you are out of the game.
If you wait, take time, assess the situation and then pounce like a jaguar at the right opportunity, your chances for trader longevity increase significantly. You have preserved your financial capital, and deployed it appropriately with a good risk/reward ratio.
The most difficult thing for traders to do is to sit there and wait. Why? Because, we live in a world that is on a total dopamine, hypomanic binge. This is never more clearly manifest than by those who absolutely have to be in the markets at all times, desperately need to be trading and simply cannot wait. They are human do-ings, rather than human be-ings.Baker & Nofsinger, eds., Behavioral Finance
Behavioral Finance: Investors, Corporations, and Markets, edited by H. Kent Baker and John R. Nofsinger (Wiley, 2010) is a must-have book for anyone who wants a comprehensive review of the literature on behavioral finance. In thirty-six chapters academics from around the world write about the key concepts of behavioral finance, behavioral biases, behavioral aspects of asset pricing, behavioral corporate finance, investor behavior, and social influences. The book is hefty (757 pages of typographically dense text), and each contribution includes an extensive bibliography. But this is not simply a reference book; it reads surprisingly well.
Why should we study behavioral finance? “Anyone with a spouse, child, boss, or modicum of self-insight knows that the assumption of Homo economicus is false.” (p. 23) In our investing and trading—indeed, in all the financial decisions we make, we are prone to behavioral biases; we are often inconsistent in our choices. Only if we understand the kinds of emotional pulls that negatively affect our financial decisions can we begin to address them as problems. Some of the authors offer suggestions for overcoming these problems.
Here are a few takeaways from the book that give a sense of its tone and breadth.
First, I am happy to report that the literature shows that “high-IQ investors have better stock-picking abilities” than low-IQ investors and they “also appear more skillful because they incur lower transaction costs.” (p. 571) I figure that everyone reading this review falls into the Lake Wobegon category.
Second, individual investors can form powerful herds. “[T]rading by individuals is highly correlated and surprisingly persistent. …[I]ndividual investors tend to commit the same kind of behavioral biases at or around the same time [and hence] have the potential of aggregating. If this is the case, individual investors cannot be treated merely as noise traders but more like a giant institution in terms of their potential impact on the markets.” (p. 531)
Third, what are some of the behavioral factors affecting perceived risk? Although the author lists eleven factors, I’ll share just two. “Benefit: The more individuals perceive a benefit from a potential risky activity, the more accepting and less anxiety (fear) they feel…. Controllability: People undertake more risk when they perceive they are personally in control because they are more likely to trust their own abilities and skills….” (p. 139)
And finally, investors’ attitude toward risk is not fixed. They care about fluctuations in their wealth, not simply the total level. “[T]hey are much more sensitive to reductions in their wealth than to increases,” and “people are less risk averse after prior gains and more risk averse after prior losses.” (p. 355) Interestingly, CBOT traders tend to exhibit a different pattern, reducing risk in the afternoon if they’ve had a profitable morning.
As should be expected in this kind of volume, there is a fair amount of repetition. The same studies are quoted by several authors. We read about such topics as overconfidence and the disposition effect multiple times. The context is different, the principles are the same. But through repetition we come to appreciate the scope of behavioral finance (and often its limitations as well).
Although this book is certainly no primer, the reader needs only a passing familiarity with behavioral finance to profit from it. And for those who are better acquainted with the field, it is a useful compendium and an excellent research tool. It has earned a place in my library.