I Suck. So Do You.

My last post pretended to not be insulting you when I said you had a flawed and emotional monkey brain. My only defense for being so rude is that:

a) I have an emotional and flawed monkey brain too.

b) This is the Internet, and you are allowed to be rude on the Internet.

The limitations of my brain fascinate me. Despite my fancy education*, I make logical errors, emotional decisions and biased judgments all the time. And that is just the ones I am aware of: an independent observer could probably spot many more.

This topic is of considerable importance for a trader. As a trader, your main enemy is not the guy on the other side of the trade: he hates you of course, but your main enemy is yourself. All of your trading decisions and non-decisions are influenced by your biases, and it is important to try to identify when they are at work.

The academic and popular literature dealing with how our brains actually work (as opposed to how economists would like to pretended they work so that their equations are neater) has grown significantly. Since I am currently on a beach vacation drinking brightly colored drinks with little umbrellas in them, please indulge me as I liberally reference other people’s hard work.

The excellent Psy-Fi Blog has a fantastic page of Behavioral Biases that gives a long list of irrational and slightly odd behaviors that investors exhibit. It is well worth a read.

Some of my favorites are:

Anchoring: our habit of focusing on one salient point and ignoring all others, such as the price at which we buy a stock.

Bias Blind Spot: we agree that everyone else is biased, but not ourselves.

Confirmation Bias: we interpret evidence to support our prior beliefs and, if all else fails, we ignore evidence that contradicts it.

Disposition Effect: we prefer to sell shares whose value has increased and keep those whose value’s dropped.

Framing: the way a question or situation is framed can determine your response.

Fundamental Attribution Error: we attribute success to our own skill and failure to everyone else’s lack of it.

Herding: we tend to flock together, especially under conditions of uncertainty.

Illusion of Control: we do things that make us feel in control, even if we’re not.

Loss Aversion: we do stupid things to avoid realizing a loss.

Overconfidence: we’re way too confident in our abilities, which seems to be an in-built bias that we’re unable to overcome without excessive effort.

Blogger Mark Dow identifies four main takeaways from the behavioral finance literature:

1) We overestimate our abilities, our uniqueness, and our objectivity, even more so when under emotional strain…

2) We systematically understate the role of ‘random’. We crave order, and we are willing to torture the facts to get there. But sometime things just happen, and sometimes problems don’t have solutions…

3) People will find a way to believe what they are incented to believe. As the saying goes, “The most dangerous place to stand is in between someone and what they want to believe”…

4) When presented with points 1, 2, and 3, almost everyone recognizes their validity, but believes at some level that he/she is exempt…

I recently read Thinking, Fast and Slow by Daniel Kahneman. It is an intelligent, interesting and well-presented book that I would recommend to anyone interested in why humans act the way they do, and to traders in particular. The book highlights a long list of human quirks and foibles that deviate us from the “rational man” so beloved of classical economics, including many identified by the Psy-Fi Blog.

For me, one of the key points that Kahneman made was that the participants in their experiments were often intelligent, educated people. When reading about the cognitive errors that people make in experiments, it is easy and satisfying to think “Oh, there’s no way I would make that mistake, it is so obvious”. Welcome to the Bias Blind Spot: we agree that everyone else is biased, but not ourselves.

I am biased and flawed. So are you. We both suck. I think that acknowledging that helps to make me a better trader.

* Potentially, this might actually be because of my fancy education. I trained as an economist, and economists are notoriously more selfish, biased and unaware than the rest of the population.

Trader 101

I am a professional trader. I seek exceptional risk-adjusted returns. I try to grow my money faster than the risk-free interest rate, whilst avoiding the large draw-downs associated with the traditional investment styles e.g. “buy-and-hold”, “60/40”. Specifically, in my personal accounts I aim for returns of 30% or more a year, while limiting draw-downs to less than 10%. I look to compound these returns over long periods of time.

I trade to make money. I do not trade for excitement, ego-validation or self-justification. For those things, I drive my car really fast, I jump out of airplanes and I have a loving family to tell me that I am awesome. Knowing why you do something, and being honest with yourself about it, is important. In Market Wizards Ed Seykota says, “Win or Lose, everyone gets what they want out of the market”. The market will give you what you want, so you have to know what you are really after.

You need to know who you are, and your place in the market ecosystem. Markets are made of a wide range of participants: market-makers, hedgers, institutional investors, investment funds and speculators. I am a speculator. Speculators have one chief advantage over other market participants: they can choose how and when to engage the market. Other participants, to varying degrees, have to be in the market all the time whereas speculators can refuse to participate until they see the right opportunity.

Since you have the freedom to choose when to participate, it is important to take advantage of it. This means being agnostic regarding market direction. I have no inherent bias towards any market: I can be long or I can be short. I can be long one day and then short the next. I have been known to flip my market position and opinion on a dime as the market conditions demand.

I am both incredibly fickle and incredibly loyal. If a market is kind to me and my position is making money, I can be loyal until the end of days: I will wine her, and dine her, and perhaps even sixty-nine her. If a market turns on me and treats me bad, I become incredibly impatient and move on to the next good thing.

Large, liquid, transparent public markets provide a wide range of opportunities to achieve my goals. These markets are very efficient mechanisms for transferring wealth from the many to the few. Most market participants lose money: in order to make money you have to do what other people do not do. Since most people do what they find psychologically easy, to make money you have to do things that are psychologically difficult.

Like most traders, I struggle to do what is difficult, to trade the plan, to control my emotions. Along the way, I have learned some tricks, some strategies and some road signs in the mist. The next few posts will explore some of the difficulties of being a trader, and some of the solutions I have picked up.