Against Our Primitive Nature In Trading 🐵

9 Agu 2022

• “I think investment psychology is by far the most important element, followed by risk control, with the least important consideration being the question of where you buy and sell.”

~Tom Basso, Market Wizard


A strong psychological foundation is the key to successful investing. The human mind is a powerful, complex tool that quickly turns into a double-edged sword to those untrained in its control.

It’s like driving a Formula-1 race car. A skilled driver can push his racer to its limits, extracting every last bit of performance. A novice driver on the other hand is better off in a mini-van. Put him behind the wheel of an F-1 and he’ll end up crashing straight into a wall.



Psychology, or emotional strength, is the basis on which high-performance skills are built. It doesn’t matter whether it’s top performing traders, all-star athletes, or extreme back-country skiers. When it comes to risky, high-pressure situations, the mind either snaps into a flow state or crashes and burns.

Decision quality in these high-stress situations requires a person to be emotionally sound. And the only way to develop this emotional toughness is through consistent self-reflection. The goal is to intimately understand both your strengths and weaknesses.

It’s been said that investing is the best way for a person to truly understand himself. The markets will quickly unveil every character flaw, insecurity, and weakness that lies inside. This is the nature of the market and it’s why emotions tend to run wild within it. Fear, greed, hope, self-doubt…..it takes psychological preparation to manage this barrage. The failure to do so leads to disaster.

To deal with these emotions, it helps to understand how the mind originally developed. Humans evolved over millions of years, spending a majority of their time roaming the planet as tribal hunters and gatherers. The advent of cities with large populations is relatively new considering that the Agricultural Revolution was only 10,000 years ago — a small tick of time in the grand scheme of human existence.

The fact that our brains were primarily developed within the harsh tribal lifestyle has many implications on our psychological makeup. It also explains why our pre-wired instincts naturally make us horrible traders.

So then what’s the deal with emotions? Are they an inherent weakness to humans?

NOPE!!!

In fact, emotions are very useful in certain situations.

Think back to the plains life:

A tribal man is walking back from a hunt when he’s suddenly confronted by a mountain lion. As the lion comes into view, his brain’s amygdala triggers a fight-or-flight response. The man is instantly hit with various emotions like fear, aggression, anxiety, etc. At the same time, physiological changes take place in his body. Hormones like adrenaline, testosterone, and cortisol are let loose to prep the man to either fight or run.



The man’s emotional/physiological response not only makes him stronger and more capable to survive this encounter, but it also enables him to make a decision in the blink of an eye. There’s no time to sit and ponder the best course of action in a life-or-death situation. Speed is key and emotions are instrumental in fueling rapid decision making.


Okay, so emotions are great when it comes to dealing with mountain lions… but what about in present day market situations?

Consider this:

A man’s entire life savings is invested in SPY. All of a sudden, the market plummets 5%. And then another 6% the next day. The man is faced with both extreme volatility and huge losses. His family’s financial security is on the line. If he loses his savings, he can’t send little Timmy off to college. And if Timmy doesn’t go to college, he’ll definitely end up flipping burgers for the next 30 years at the fast food joint down the street. It’s a life-or-death situation. A decision needs to be made quickly. *Queue the mountain lion emotional/psychological response.*

Rampant emotions are no good here. Rapid, haphazard decision making doesn’t help either. The man’s love for Timmy will only lead him to make irrational choices that’ll destroy his savings in the long run.

In scenarios like this, the fight-or-flight response works against you. This is where cool-headed, rational decisions prevail. A trader needs to transfer his decision making from his emotional Amygdala to his rational prefrontal cortex. Doing so will help him overcome his immediate emotional and physiological responses in order to make a more sound decision for his savings.

In addition to controlling these emotions, we also have to contend with our strong evolutionary desire to “fit in”.

Think back to our plains-roaming ancestors again. They used to move in small packs that would provide each other with protection and support. All basic needs like food and shelter were met through the group.

This reality made it vital that an individual be accepted by his group. If he wasn’t well-liked, he’d be ostracized and forced to leave, which was the equivalent of a death sentence in those days. A tribeless person would have a difficult time surviving alone and exposed in the wild.

The conformists of the group were the ones who survived the longest. They were also the ones who reproduced the most, passing on their genetic code. The “fitting in” mentality became a dominant survival trait that grew stronger as it passed from generation to generation over millions of years. This is the reason we’re all born with the natural need to be accepted by others. Doing something that goes against the tide, especially something that could cause us to be rejected from our group, goes completely against our nature.

This mentality may have made sense in the past, but it doesn’t make sense today… especially in markets.

Does It Pay To Always Go With The Crowd Or Does It Pay To Think For Yourself?

The answer is obvious — it pays to think for yourself.

And many times independent thinking will lead you to do the exact opposite of the crowd.

As Warren Buffet once said regarding Berkshire Hathaway’s success —


*“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

Take March 2009 for example. Fear was running rampant and no one wanted to invest post-crisis. But this was the time when valuations were ripe for the picking. The market was getting ready to turn around.

Going against the crowd and investing big during this period — being greedy when others were fearful — would have made you a fortune.

This is why it’s so important to avoid falling victim to groupthink. An investor needs to make his own decisions based on his own convictions.

But of course this isn’t easy.

Thinking For Yourself Means Violating Your Biological Need To Be Accepted By Others. It Automatically Feels Unsafe And Uncomfortable. But The Ability To Manage This Negative Emotional Reaction That Comes With Independent Thinking Is The Key To Long-term Success.






AVOIDING COGNITIVE BIASES IN TRADING.


On top of rampant emotions and a dire need to “fit in”, our biological evolution also had another side-effect. It made us lazy.

Back in the day we were faced with an endless cycle of feast and famine. We’d have short periods of feeding followed by long periods of minimal sustenance living. So naturally we evolved to conserve our energy as much as possible.

If given two options we’re conditioned to choose the one that involves the least amount of effort. This applies not only to physical activities, but to mental functions as well. After all, the brain does account for up to 20% of the body’s total energy usage (more than any other organ). We’ll always go for the quick and easy solution over the tough one that requires more thinking. This is true even if the easy option ends up being wrong…

To help facilitate this low-effort decision making we’ve developed Heuristics. Heuristics are simple, efficient rules we use to quickly make decisions and form judgments. They’re mental shortcuts that slice through complexity.

Yet even though these Heuristics tend to work well most of the time, they can also lead to decisions devoid of rationality and logic. The resulting errors are what we call cognitive biases. Understanding these biases is important to help avoid them when making our trading decisions.




Recency Bias


Recency bias is believing what occurred in the recent past will continue to occur in the future.



Say you flip a coin and get heads five times in a row. Naturally you’ll begin to think the sixth flip will also be heads. Heads is the trend.

But in reality, you’d be wrong. This is called recency bias. You’re letting recent outcomes incorrectly influence your belief of future outcomes.

No matter the outcome of the previous trials, the probability of the next coin flip being heads will always be 50%. Believing anything else is illogical.

Investors consistently fall victim to this bias. It’s the main contributor to the complacency we see during each market cycle.

Consider the “buy the dip” mentality that plagued the post-QE era. One of the greatest financial crises in history occurred 8 years prior, and in the time in between investors trained themselves to throw risk management out the window and aggressively buy more each time the market fell.

It’s true that “buy the dip” worked well during that time, but there was no guarantee it would work in perpetuity. This is especially true considering the nature of market cycles. Strategies tend to work for a period of time until they don’t. And it’s usually the previously successful strategies that end up failing the hardest in the new environment. No one wants to be caught buying the dip when the market morphs from bull to bear. But unfortunately, recency bias leads a majority of investors straight off that cliff.

“Buy the dip worked before… so it must work again!”

Nope. Sorry.




Gambler’s Fallacy

On the other side of the coin (pun intended) we have the gambler’s fallacy (also known as the Monte Carlo fallacy).




This is the opposite of recency bias. It occurs when you start believing that because a certain result happened more frequently in the past, there’s a higher probability a different result will occur in the future.

Take the coin flip example again. Someone who flipped heads five times in a row may think the next flip has to be tails because of the 50% probability associated with the game.

This is once again illogical.

Over a large enough sample of trials (which can be performed through a Monte Carlo simulation), the number of heads and tails will be evenly split. But over any individual, shorter stretch, there is no requirement they must show up equally. You can have 100 head flips in a row and yet the probability of the next flip will still be 50% heads, 50% tails. The Gambler’s Fallacy is thinking the probability of a tails flip has increased based on the previous streak.

Our “buy the dip” example once again shows the dangers of this bias in markets.

The post-QE era was littered with the corpses of fund managers who tried to short the indices. Why’d they do it? It’s because they thought that after working so many times, “buy the dip” had to fail eventually.

“Business cycles only last 5-7 years. It’s due time for the market to correct for real and blow out all these “buy the dip” idiots.”

Again, this is not how it works. As John Maynard Keynes once said:

“The market can stay irrational longer than you can stay solvent.”




Sunk-Cost Fallacy / Loss-Aversion




A sunk-cost fallacy is continuing an endeavour due to previously invested resources (time, money, effort) even when the optimal decision is to stop.

Ever get full at dinner, but finish your plate anyway because you don’t want to waste the good money you paid for it? That’s the Sunk-cost Fallacy in action.

Loss-aversion is the tendency to strongly prefer avoiding losses to acquiring equivalent gains. The pain of losing greatly overwhelms the pleasure of gaining.

Marketers use Loss-aversion all the time. Which of the following headlines make you want to buy more?


“Buy our insurance and save $100 a month!”

Or

“You’re losing $100 a month on insurance. Buy ours and save!”

The second one of course. The thought of losing $100 is much more powerful than the thought of just saving it.

Both Loss-aversion And The Sunk-cost Fallacy make it difficult to cut losses in the market.

No one wants to cut a losing position after spending countless hours developing a thesis. It feels like a waste… all that work for nothing. It becomes easy to find yourself attached to an investment because of the Sunk-cost Fallacy.

But this mentality is completely irrational. Refusing to cut a loser, regardless of the initial time investment, leaves you exposed to an even larger total loss (time & capital) down the line.

Cutting a loss also becomes even harder when loss-aversion comes into play. Taking a loss not only means admitting you’re wrong, but also turns your paper loss into a real account drawdown. This is too much to handle for most, even if it’s in their best interest. The illogical fear of taking the pain now opens the door to even more pain in the future.




Confirmation Bias




Confirmation bias is seeking out information that supports an initial thesis while disregarding all else.

Rose-colored glasses are a large problem in the investment world. Too many investors find a company they like and then proceed to become its #1 cheerleader. They only look for news and press releases that support their positive image of that company. Any fundamental warning signs are immediately disregarded and objectivity is squashed.

This is asking to be unpleasantly surprised in the future. Confirmation bias creates a dangerous blind spot that has a high likelihood of decimating a trading account.




Observational Selection Bias


Similar to Confirmation Bias, Observational Selection Bias involves noticing a particular idea and then falsely assuming that the frequency of available evidence supporting that idea has increased.

Say you develop a thesis that Solar Stocks should take off soon. And as soon as you create that thesis, you start to notice a huge increase in News stories and data that support it. This makes you even more confident in Solar Stocks.

This is most likely the bias in action.

Developing your initial solar thesis has you primed towards certain types of information. This priming is very easily confused with actual increasing sentiment towards the solar sector. Objectivity is once again smothered, making this bias crucial to avoid.

These Cognitive Biases are completely natural to have. And that’s what makes them dangerous. We need to stay vigilant of these biases to make sure they don’t creep into our analysis process. Objective analysis is the key to success in the markets. But for objective analysis to flourish, biases need to be squashed.







PLAN YOUR TRADES AND TRADE YOUR PLAN


Clearly Our Biology And The Biases That Come With It Are Hazardous To Our Financial Health.

But how exactly do we solve this problem?

The trick is to Plan Your Trades And Trade Your Plan.


The First Step To Successful Trading Is Creating A Solid Strategy That Accounts For Every Possible Market Scenario. High Volatility, Low Volatility, Black Swans, It Doesn’t Matter. Everything Should Be Planned For. Nothing Should Be A Surprise.

A Detailed Strategy Will Pre-plan The Action Steps You’ll Take In Specific Market Situations. This Ensures You’ll Have Strict Guidelines To Follow When Your Emotions Inevitably Run Wild. Your Past Objective Mind Will Have Already Made The Correct Decisions For Your Current, Emotionally Charged, Irrational Mind. This Is How You Avoid Destructive Choices In The Heat Of The Moment.

But This Only Works If You Actually Execute Your Plan When The Time Comes. This May Sound Simple. And Honestly It Is. But That Doesn’t Mean It’s Easy. Execution Is Difficult Because Our Biological Wiring Does Everything In Its Power To Prevent Us From Pulling The Trigger. Our Emotions And Biases Flare Up And We’re Forced To Do Battle With Them Before All Else.

The Best Trading Plan In The World Won’t Prevent Your Fight-or-flight Response. It Won’t Cure Your Dire Need To Stick With The Herd Or Your Cognitive Biases Either. You’ll Still Experience All The Feelings That Come With Your Biological Reality. There’s No Way Around It.

That’s why you need to accept it. Let the process play out. Feel what you’re feeling. But as it happens, take a step back, and from a distanced view, fully acknowledge what’s occurring. Objectively analyze it:

“The market just dropped 400 points and I’m feeling x, y, and z. Why am I feeling like this? Should I be feeling this way? How should I react?”

Explicitly following through with this exercise, either mentally, or even better by physically writing these questions and answers down, immediately switches your brain from using its emotional Amygdala to its rational prefrontal cortex. The process will prevent the type of knee-jerk decisions you’re trying to avoid while reminding you to stick to your pre-defined trading plan.

Another effective tactic to ensure execution is reducing your stimuli. If the market is crashing, don’t sit in front of your computer screen and watch it. Every tick will cause an emotional response. And the more frequently you have to deal with these emotional responses, the more likely you’ll succumb to them and deviate from your trading plan.


Just like you don’t trust a toddler with a bunch of colored markers in an empty, white-walled room, we don’t trust ourselves with a mouse and keyboard during trading hours. Both result in a mess.

As the Legendary Trader Peter Brandt said:


*“Trading [is] an upstream swim against human emotions.”


These are wise words from a wise man. Plan your trades and trade your plan. That’s How You’ll Win In The End.


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