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Trading Psychology

Trading psychology (Prospect Theory+Cognitive Biases)

Prospect Theory:

Nobel prize winner Daniel Kahneman (Economics) presented prospect theory which tries to describe the way people will behave when given choices which involve probability. Prospect theory assumes that individuals make decisions based on expectations of loss or gain from their current relative position. An important element of prospect theory is the idea that individuals are particularly averse to losing what they already have and less concerned to gain. Prospect theory can explain why people exhibit both risk-seeking and risk-averse behaviour.

Features of Prospect Theory:

Prospect theory places emphasis on how individuals frame situations and outcomes in their mind. Individuals may use rules of thumbs and the status quo bias.

Certainty effect: People give greater weighting to certainty than outcomes that are merely probable.
Reflective effect. In terms of positive gains, people give greater weighting to a small certain gain over a probable larger gain. But, in terms of negative gains, people exhibit risk-seeking behaviour – people preferring a loss that is probable over a small loss that is certain. (this seems to contradict the desire for insurance, but it is for moderate losses, rather than catastrophic losses.)
Based on results from controlled studies, it describes how individuals assess their loss and gain perspectives in an asymmetric manner (see loss aversion). For example, for some individuals, the pain from losing $1,000 could only be compensated by the pleasure of earning $2,000. Thus, contrary to the expected utility theory (which models the decision that perfectly rational agents would make), prospect theory aims to describe the actual behavior of people.

Cognitive Biases :

According to conventional financial theory, the world and its participants are rational human being and strive to maximize their wealth prudently. However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways. Dean of Wall Street, Mr. Benjamin Graham stated in his popular book “The Intelligent Investor” that markets are more psychological and less logical. Behavioural finance, a relatively new field of finance, attempts to combine behavioural and psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.

Simon Savage, co-head of European and global long/short strategies at GLG Partners, a hedge fund manager owned by Man Group, said: “We were all born to be bad fund managers because of inbuilt behavioural biases, which are present in everyone to various degrees. It’s through an awareness of them that as a fund manager you can begin to build a defence mechanism to avoid these vulnerabilities. Ignore them at your peril.” Here are some of the main behavioural biases that investors need to look out for:

Loss-aversion bias: Loss aversion refers to investor's tendency to strongly prefer avoiding losses to acquiring gains. The fear of loss leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure of gain of a similar magnitude. Investors prefer to do nothing despite information and analysis favouring a particular action that in the mind of the investor may lead to a loss. Holding on to losing stocks, avoiding riskier asset classes like equity when there is a lot of information and discussion going around on market volatility are manifestations of this bias. In such situations, investors tend to frequently evaluate their portfolio’s performance, and any short-term loss seen in the portfolio makes inaction their preferred strategy.

Confirmation bias: Confirmation bias, also called my side bias, is the tendency to search for, interpret, or prioritize information in a way that confirms one's beliefs or hypotheses. It is a type of cognitive bias and a systematic error of inductive reasoning. For example, when a trader buys a stock for a reason and that reason doesn’t work out so the trader makes up another one for owning the position. Similarly, first we make decision in mind and then find for the information to justify that intuitive decision.

Ownership bias: Things owned by us appear most valuable to us. Sometimes known as the endowment effect, it reflects the tendency to place a higher value on a position than others would. It can cause investors to hold positions they would themselves not buy at the current level.

Gambler’s fallacy: Predicting absolutely random events on the basis of what happened in the past or making trends when there exists none. It is the mistaken belief that if something happens more frequently than normal during some period, then it will happen less frequently in the future, or that if something happens less frequently than normal during some period, then it will happen more frequently in the future (presumably as a means of balancing nature). Winner’s curse: Tendency to make sure that a competitive bid is won even after overpaying for the asset. While behaviourally it is a win, financially, it may be a loss.

Herd mentality: This is a common behaviour disorder in investing community. This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Such choices may seem right and even be justified by short-term performance, but often lead to bubbles and crashes. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction. Most of the individuals don’t go against the crowd as economist John Maynard Keynes said: “It is better for reputations to fail conventionally than to succeed unconventionally.”

Anchoring: Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered when making decisions. Investors hold on to some information that may no longer be relevant, and make their decisions based on that. New information is labelled as incorrect or irrelevant and ignored in the decision making process. Investors who wait for the ‘right price’ to sell even when new information indicate that the expected price is no longer appropriate, are exhibiting this bias. For example, they may be holding on to losing stocks in expectation of the price regaining levels that are no longer viable given current information, and this impacts the overall portfolio returns. Actually, the decision should be made purely on the basis of what price and value difference exist today in light of available information rather than based on what the prices were in the past.

Projection bias: We project recent past to the distance future completely ignoring the distant past.

While Booms and busts are the way of market, maintaining sanctity and discipline is what great investors in the world teach us. Here are some pearls of wisdom from some of these great masters:

Charlie Munger:

“Understanding how to be a good investor makes you a better business manager and vice versa.”

Walter Schloss:

“If you can't find good value investing positions, park your money in cash.”

David Dreman:

"Psychology is probably the most important factor in the market – and one that is least understood."

John Tempelton:

"Invest at the point of maximum pessimism."

Peter Lynch:

"Go for a business that any idiot can run – because sooner or later, any idiot is probably going to run it."

Benjamin Graham:

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."

Warren Buffett:

"Rule No.1 is never lose money. Rule No.2 is never forget rule number one."

•Availability heuristic bias

•Mood-congruent bias

•Attentional bias

•Omission bias

•Confirmation bias

•Zero sum bias

•Hindsight bias

•Outcome bias

•Restraint bias

•Zero sum bias

•Empathy gap

•Bandwagon effect

•Overconfidence effect

•Dunning Kruger Effect

•Peltzman effect

•The disposition effect

•Illusory truth effect

•Mere-exposure effect

•Restorff effect

•Focusing effect

•Framing effect

•The less is better effect

•Pseudo Certainty Effect

•Backfire effect

•Reverse Psychology

•Operational Logic

•Blind spot

•Clustering illusion

•Naive Realism

•Gambler’s Fallacy

•Sunk cost Fallacy

•Hot hand Fallacy

•Weber-Fechner Law

•Semmelweis Reflex

•Baader-Meinhof phenomenon

•Hyperbolic Discounting

•Irrational Escalation

List of Cognitive Biases (180+)

The 5 Stages Of A Trader’s Development:

Stage One: Unconscious Incompetence

This is the first step you take when starting to look into trading. You know that it is a good way of making money because you’ve heard so many things about it and heard of so many millionaires. Unfortunately, just like when you first desire to drive a car you think it will be easy – after all, how hard can it be? Price either moves up or down – what’s the big secret to that then – let’s get cracking!

Unfortunately, just as when you first take your place in front of a steering wheel you find very quickly that you haven’t got the first damn clue about what you’re trying to do.

You take lots of trades and lots of risks. When you enter a trade, it turns against you, so you reverse and it turns again, and again, and again. You may have initial success and that’s even worse because it tells your brain that this really is simple and you start to risk more money. You try to turn around your losses by doubling up every time you trade. Sometimes you’ll get away with it but more often than not you will come away scathed and bruised. You are totally oblivious to your incompetence at trading.

Stage Two – Conscious Incompetence

Stage two is where you realize that there is more work involved in trading and that you might actually have to work a few things out. You consciously realize that you are an incompetent trader – you don’t have the skills or the insight to turn a regular profit. You now set about buying trading systems and e-books galore, read websites based everywhere from USA to the Ukraine and begin your search for the holy grail. During this time you will be a system nomad – you will flick from method to method day by day and week by week never sticking with one long enough to actually see if it does work. Every time you come upon a new indicator you’ll be ecstatic that this is the one that will make all the difference.

You will test out automated systems, you’ll play with moving averages, Fibonacci lines, support & resistance, pivots, fractals, divergences, DMI, ADX, and a hundred other things all in the vain

hope that your ‘magic system’ starts today. You will also become a top and bottom picker, trying to find the exact point of reversal with your indicators and you’ll find yourself chasing losing trades and even adding to them because you are so sure you are right.

You’ll go into the live chat room and see other traders making profits and you want to know why it’s not you. You’ll ask a million questions, some of which are so dumb that looking back you feel a bit silly.

You’ll then reach the point where you think all the ones who say they are making profits are all liars – they can’t be making that amount because you’ve studied and you don’t make that, you know as much as they do and they must be lying. But they’re in there day after day and their account just grows while yours falls. You will be like a teenager – the traders that make money will freely give you advice but you’re stubborn and think that you know best. You take no notice and overtrade your account even though everyone says you are mad to, but you know better.

You’ll consider following the calls that others make but even then it won’t work so you try paying for signals from someone else – they don’t work for you either.

You might even approach a guru or someone on a chat board who promises to make you into a trader (usually for a fee of course). Whether the guru is good or not you won’t win because there is no replacement for screen time and you still think you know best. This stage can last ages and ages – in fact in reality talking with other traders as well as personal experience confirms that it can easily last well over a year and more nearer to three years. This is also the stage when you are most likely to give up through sheer frustration. Around 60% of new traders quit in the first 3 months – they give up and this is good –think about it – if trading was easy we would all be millionaires.

Another 20% keep going for a year and then in desperation take risks guaranteed to blow their account which of course it does. What may surprise you is that of the remaining 20% all of them will last around 3 years and they will think they are safe in the water but even at 3 years only a further 5-10% will continue and go on to actually make money consistently. By the way – these are real figures, not just some I’ve picked out of my head – so when you get to 3 years in the game don’t think it is plain sailing from there! I’ve had many people argue with me about these timescales – funny enough none of them have been trading for more than 3 years – if you think you know better – then ask on a board for someone who’s been trading 5 years and ask them how long it takes to become fully 100% proficient.

Sure, I guess there will be exceptions to the rule – but I haven’t met any yet. Eventually you do begin to come out of this phase. You’ve probably committed more time and money than you ever thought you would, lost 2 or 3 loaded accounts and all but given up maybe 3 or 4 times but now it is in your blood. One day – in a split second moment you will enter stage 3.

Stage Three – The Eureka Moment

Towards the end of stage two you begin to realize that it’s not the system that is making the difference. You realize that it is actually possible to make money with a simple moving average and nothing else IF you can get your head and money management right. You start to read books on the psychology of trading and identify with the characters portrayed in those books and finally come the eureka moment. This eureka moment causes a new connection to be made in your brain. You suddenly realize that neither you, nor anyone else can accurately predict what the market will do in the next ten seconds, never mind the next 20 minutes.

Because of this revelation you stop taking any notice of what anyone thinks – what this news item will do, and what that event will do to the markets. You become an individual with your own method of trading. You start to work just one system that you mold to your own way of trading, you’re starting to get happy and you define your risk threshold. You start to take every trade that your ‘edge’ shows has a good probability of winning with.

When the trade turns bad, you don’t get angry or even because you know in your head that as you couldn’t possibly predict it it isn’t your fault – as soon as you realize that the trade is bad you close it. The next trade or the one after it or the one after that will have higher odds of success because you know your system works. You stop looking at trading results from a trade-to-trade perspective and start to look at weekly figures knowing that one bad trade does not a poor system make.

You have realized in an instant that the trading game is about one thing – consistency of your ‘edge’ and your discipline to take all the trades no matter what as you know the probabilities stack in your favor. You learn about proper money management and leverage – risk of account etc. – and this time it actually soaks in and you think back to those who advised the same thing a year ago with a smile. You weren’t ready then but you are now. The eureka moment came the moment that you truly accepted that you cannot predict the market.

Stage Four – Conscious Competence

You are making trades whenever your system tells you to. You take losses just as easily as you take wins. You now let your winners run to their conclusion fully accepting the risk and knowing that your system makes more money than it loses and when you’re on a loser you close it swiftly with little pain to your account. You are now at a point where at a minimum you break even – day in day out. You will have weeks where you make big money and other weeks where you lose big money – but overall you are breaking even and not losing money anymore. You are now conscious of the fact that you are making calls that are generally good and you are getting respect from other traders as you chat the day away. You still have to work at it and think about your trades but as this continues you begin to make more money than you lose consistently. You’ll start the day on a big win, take a big loss and have no feelings that you’ve given those profits back because you know that it will come back again. You will slowly begin to make consistent profits week in and week out.

Stage Five – Unconscious Competence

Now we’re cooking – just like driving a car, every day you get in your seat and trade. You do everything now on an unconscious level. You are running on autopilot. You start to pick the really big trades and getting big profits in a day doesn’t make you any more excited that getting none. You see the newbies in the forum shouting ‘go market go’ as if they are urging on a horse to win in the grand national and you see yourself – but many years ago now. This is trading utopia – you have mastered your emotions and you are now a trader with a rapidly growing account.

You’re a star in the trading chat room and people listen to what you say. You recognize yourself in their questions from about two years ago. You pass on your advice but you know most of it is futile because they’re teenagers – some of them will get to where you are – some will do it fast and others will be slower – literally dozens and dozens will never get past stage two, but a few will.

Trading is no longer exciting – in fact it’s probably boring you to pieces – like everything in life when you get good at it or do it for your job – it gets boring – you’re doing your job and that’s that. Finally you grow out of the chat rooms and find a few choice people who you converse with about the markets without being influenced at all. All the time you are honing your methods to extract the maximum profit from the market without increasing risk. Your method of trading doesn’t change – it just gets better – you now have what women call ‘intuition.’ You can now say with your head held high “I’m a trader” but to be honest you don’t even bother telling anyone – it’s a job like any other.

I hope you’ve enjoyed reading this journey into a traders mind and that hopefully you’ve identified with some points in here. Remember that only 5% will actually make it – but the reason for that isn’t ability, its staying power and the ability to change your perceptions and paradigms as new information comes available. The losers are those who wanted to ‘get rich quick’ but approached the market and within 6 months put on a pair of blinkers so they couldn’t see the obvious – a kind of “this is the way I see it and that’s that” scenario – refusing to assimilate new information that changes that perception.

I’m happy to tell you that the reason I started trading was because of the ‘get rich quick’ mindset. Just that now I see it as ‘get rich slow.’ If you’re thinking about giving up I have one piece of advice for you:

Ask yourself the question “How many years would you go to college and pay the fees if you knew for a fact that there was a million dollars a year job at the end of it?”

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