How To Stop Making Idiot Trading Decisions
Source : Forbes
How many times has it happened? You’ve looked back on a losing trade or investment and thought to yourself, “How could I have been such an idiot?!” What seemed like a good decision at the time is now, in retrospect, clearly one you’d never make in your right mind.
If it seemed as though you were out of your mind at the time you made your poor decision, the chances are good that that is precisely what happened. As Daniel Kahneman explains in his Thinking, Fast and Slow, our one brain possesses multiple information processing systems. The actions we take when we are thinking fast and responding to the hopes and threats of the moment are not those we would necessarily take when we are thinking slowly and deeply, carefully analyzing risks and rewards.
Our fast processing is fast because it takes shortcuts and operates by well-worn rules. This introduces efficiency, which is very helpful when we need to act quickly in a life-threatening situation. It also introduces biases into decision making, as when we personalize markets and respond to losing trades with anger, placing subsequent trades out of a desire for revenge. We invest and trade like idiots when we engage the wrong information processing system in our real-time decision-making.
Mike Bellafiore recently described a situation in which a smart trader made a stupid trading mistake. Having made a good amount of money for his stage of development, he placed an oversized bet on a completely new strategy. This resulted in losing far more money than he wished. When Mike asked what he had learned from the experience, the trader cited overconfidence and excessive risk-taking.
It’s a good answer, but not a great one. The important question is, “What caused you to be overconfident, and why did you act on that overconfidence?” A moment’s reflection would likely reveal that the overconfidence led to excitement and enthusiasm and that it was out of that excitement that the idiot trade was placed.
This is the cause of many investment woes: Physical, emotional, and cognitive state shifts precede and impel poor trading decisions. Once we shift to a fearful, excited, frustrated, or depressed state, we process information in fast ways that would never be part of our slower, more planned deliberations.
State shifts precede lapses of discipline. We plan our trades but fail to trade our plans when our minds and bodies become dominated by fatigue, boredom, nervousness, or eagerness. What we know–the information we access at the moment–is a function of the state we occupy.
That is the reason we can keep a journal of our mistakes, talk to coaches about what we’ll do better next time, and set one corrective goal after another–only to make the same idiot mistakes again. When we plan our behavior in one mind/body state but make decisions in a very different state, our good intentions become as frail as our New Year’s resolutions.
The traditional trading psychology advice for dealing with this challenge is to control emotions, instill “discipline”, and trade with zen-like focus. There are two problems with this view. First, in my years of working with very successful hedge funds and trading firms, I’ve yet to see a portfolio manager or trader remotely approach this ideal. The advice, while superficially appealing, is tantamount to advocating a partial lobotomy: cutting off our fast information processing systems. Second, even if this were possible, it would not be desirable. That same fast thinking that can lead to idiot trading decisions is also the rapid processing that gives us the pattern recognition-based “a-ha” experience when we arrive at creative insights. Cutting off emotion eliminates the best as well as the worst of our fast thinking.
A much sounder strategy for achieving consistency is to learn from the training of military special forces teams, from Navy SEALs to Army Rangers. Their training exposes them to a variety of difficult conditions, including grueling workloads, lack of sleep, hunger, and relentless criticism. The idea is to create training conditions that approximate the rigors than the conditions the soldiers are likely to encounter. If we can learn to sustain good functioning in difficult physical and emotional situations, we’re prepared for almost any challenge.
Fortunately, investors and traders don’t need to subject themselves to months of drill-sergeant abuse to achieve robustness of functioning and decision-making. Indeed, as Martin, Goldstein, and Cialdini emphasize in their book The Small Big, we can often achieve large changes through modest changes in our routines. One such change that can make a world of difference for traders is making use of imagery and mental rehearsal to practice decision-making under conditions of shifted states. In other words, we create vivid scenarios of fear, greed, overconfidence, frustration, and surprise and play those in our minds like movies, creating moderate versions of the state shifts that bedevil our trading. While in those new states, we then focus our attention, slow our breathing, and mentally rehearse sound decision-making, activating our slower, more deliberate modes of processing.
The “small big” in this case is rehearsing good decision-making under bad conditions–and turning that rehearsal into daily preparatory routines. Psychologist Don Meichenbaum once referred to a version of this method as “stress inoculation”. We expose ourselves to a moderate level of stress in imagery (or in actual practice) and activate our mind’s defenses. Just like an inoculation of a mild active virus triggers an adaptive response from our bodies that wards off future disease viruses, the practice of sound decision-making under mild conditions of altered states helps prepare us for future market–and personal–turmoil.
There will always be surprise in markets, and there will always be wrenching setbacks, bouts of volatility, and occasions for confusion. It is not realistic to assume that we can face risk and uncertainty with a perfectly calm, stable demeanor. What we can do, however, is create a better concordance between our training and the conditions we’re likely to face in the heat of battle. Tell the same joke again and again and again and it loses its humor. It becomes boring; it no longer shifts our state. Face the same situation again and again and again and it, too, loses its impact. It’s tough to make decisions like an idiot if you’ve repeatedly rehearsed smart decision-making under challenging conditions.
