The Psychology of Trading

by Brett N Steenbarger

  The following weekend, at a party, they saw each other again. What did Bob do? Nothing!

  Why?

  "She was talking with other people," Bob explained, "so I didn't think she was interested in talking with me."

  "So what did you do?" I asked.

  "I left the party," he explained. "I just didn't want to go through rejection again."

  Two years later, Bob reentered counseling. He had found a relationship, but it was not fulfilling. For the past year, he had known that his girlfriend was cheating on him, but he could not end the relationship. Like Kahneman and Tversky's subjects and like Ken, Bob tried to protect his self-esteem by taking whatever actions he could to avoid experiencing loss. The young man who was too afraid to talk with a promising woman at a party faced far greater rejection when he was too afraid of losing an unpromising woman.

  DECISIONS AND UNCERTAINTY

  It turns out that Bob's loss aversion is part of a much larger set of cognitive and emotional biases that affect trading decisions. A growing body of research in behavioral finance has helped traders better understand these distorting influences and their potential impact on the ways traders process market events.

  In his book Beyond Fear and Greed, Hersh Shefrin summarizes two major biases that influence traders.

  1.Heuristic-driven biases. Traders create rules of thumb to help them understand and predict events and become overly caught in these imperfect heuristics. Many of the accepted pieces of wisdom among traders, such as the distrust of market declines on light volume and the notion that "the trend is your friend," are convenient heuristics that, unfortunately, do not hold up under the microscope of testing. During periods of uncertainty in the markets, traders are particularly apt to anchor themselves in such heuristics. The opening years of the new millennium witnessed the dangers of such a strategy when traders followed the heuristic that associates high levels of the short-term trading index (TRIN), or Arms Index, with superior upside returns. Thanks to the intensity of selling among large capitalization stocks during 2001 and 2002, very high TRIN readings yielded even more extreme high readings and further significant declines, especially among Nasdaq issues.

  2.Frame dependence. The frames, or ways in which situations are presented, affect how people respond to those situations. The risk aversion of Tversky and Kahneman's subjects is an excellent example. As Terence Odean's research has shown, traders who have just made some successful trades are more likely to take subsequent risky trades because they feel that they are now playing with "house money." It is not at all unusual to see traders adopt money management strategies that are a function of their most recent trades. This leads them to become overconfident and impulsive after wins and overcautious and risk averse after losses.

  A good example of how these biases come together in trading can be drawn from breakout trades. The common heuristic among traders is that breakouts from a range will lead to trending movements in the direction of the breakout. Frame dependence, however, helps to determine what traders actually view as a breakout. I have surveyed traders with charts of identical market data plotted on different scales. The points at which traders visually identify a breakout vary as a function of the price scale employed on the Y axis and the time frame covered on the X axis. I even extended this experiment and plotted chart data on a sonification grid, which assigned a distinct tone to each price level. Subjects were then asked to close their eyes and identify breakouts on the chart from the sounds they heard. The breakout points based on sound were invariably different from those based on visual inspection.

  The interesting part of these experiments is that both groups of subjects identified breakout levels well in advance of mathematical algorithms that determined when a breakout was significant. Traders who used charts or sounds to identify breakouts generally made their identification at points at which prices had gone to new highs or new lows, but at which these new highs or lows still fell within the range of random variation. The evidence of the senses, particularly under conditions of uncertainty, is not necessarily an accurate guide for decisions. Traders perceive far more significance in market data than is actually there.

  The research of Tversky and Kahneman, moreover, suggests that people continue to hang on to their faulty heuristics and conclusions long after they have obtained contrary evidence. If people can utilize their heuristics to explain most of their experience, they will be reluctant to change those ideas. In trading practice, this creates a dangerous scenario. Only when losses are extreme will traders feel the need for drastic revisions of their scenarios. This imperviousness to new evidence—especially disconfirming evidence—is a major bias interfering with good trading.

  Research conducted by Reid Hastie and Bernadette Park helps to explain this perceptual rigidity. Their work suggests that the judgments people make that are based solely on past experience are far different from those that are made "on-line," that is, in the face of fresh incoming data. In the former situation, the quality of long-term memory correlates quite well with the judgments people render. However, in those on-line situations—such as trading—a person's memory is a poor predictor of the decisions that will be made. Subjects, explain Hastie and Park, tend to make new judgments on the basis of earlier judgments and inferences, rather than on the information from long-term memory. Their findings suggest that most spontaneously generated market decisions are apt to be furthest divorced from people's actual experience, a conclusion that reinforces the value of remaining grounded in tested rules and research during the on-line flow of market events.

  In sum, it appears that people are far better at generating ideas than at revising them, especially people who are comfortable with the relative balance of risk and reward. Moreover, when uncertainty is high and the volatility of the markets requires on-the-spot decision making, people are most apt to fall prey to their cognitive and emotional biases. In a manner that seems almost cruel, nature has designed human beings in such a way as to be poor traders, ill-equipped to handle the real-time processing of risks and rewards.

  ALTERING THE RISK-REWARD EQUATION

  I knew that the only way I could help Ken was to alter the balance between perceived risk and reward. He avoided his studies because it was psychologically riskier to try and to fail than to not try at all. The key to helping Ken was the therapist's recognition that failing medical school was not his most dreaded fear. His greatest nightmare was that his father was right all along. For years, Ken had felt different from other college and medical students. He had felt a bit like an imposter, coming from a small, rural town and an uneducated, poor family. His desire was to belong. To try and then fail meant facing the devastating reality that maybe he didn't belong. Maybe he would never break free because maybe his family home was where he belonged.

  Ethologists have observed that animals will fight heatedly until it is clear that one is dominant. At that point, the loser will suddenly stop fighting and bare its throat, as if inviting the deathblow. Interestingly, this inhibits the fighting instincts of the aggressor and allows the weaker animal to go free. If only depression worked so well for people! Ken was losing his battle for independence and now sat in my office, throat bared.

  My voice was soft, as I moved closer to Ken. "I need you to do me a favor," I said. "Can you try something for me?"

  Ken looked up, a bit puzzled. The last thing he expected was for me to ask help of him. "Sure," he said.

  "Whatever you do in the next two weeks," I explained, "I want you to do it honestly. You've always been honest with yourself and your family," I said. "Can you continue that now?"

  "Yes, sure," Ken quickly replied.

  "Good," I replied, maintaining steady eye contact. "You understand that if you don't study, you'll fail the last exam and the final. That means you'll fail the course. And if you don't study for the other finals, you'll fail those courses as well. That will make you eligible for dismissal, right?"

  Ken's eyes grew wider. "Right."

/>   "So if you decide to not study, you're really deciding to leave school," I pointed out. "If we're being honest with ourselves and each other, that's the bottom line."

  "But I want to study," Ken protested. Some emotion was creeping into his voice. That was good.

  Quickly, I shot back, "No, Ken, you want to pass. The last thing you want to do is study . . . especially if you're going to get another 68."

  Ken didn't reply.

  "How would that feel to you," I asked, my voice rising. "To study your heart out and get another failing grade?"

  "I can't do it," Ken moaned, his voice again lowering.

  "You don't even want to go there, do you?"

  "No," Ken smiled slightly.

  "So you don't study. You'll take the default failure rather than put yourself through the agony of trying and then falling short. And, Ken, that's fine," I emphasized. "If that's what you choose to do, I'll support your decision. But it will be important for you to be honest about the decision."

  "What do you mean?" Ken asked, puzzled.

  "Ken," I said softly, "if you opt out of school, you're going to need a place to stay. You're going to have thousands of dollars of financial aid debt coming due. You're going to need to mend fences with your family."

  Ken's face was ashen. But he was looking directly at me, not down at the ground.

  "Ken," I intoned slowly, "you'll need to let me call your Dad and explain what happened. You'll need to apologize and swallow your pride—let him know he was right all along. For a while, at least, you're going to need him. You'll need a home base."

  "I can't do that," Ken said firmly. "No way. I'm not going to do that. Tell him I'm sorry? Tell him he was right? That I'm not good enough to make it?" Ken's voice rose, his tone indignant, not so defeated.

  "But, Ken," I continued softly. "Isn't that what you've been telling yourself? That you're not good enough to make it? All I ask is that you be honest—that what you say to yourself and what you say to your father be one and the same."

  Ken stopped short. He seemed to recognize that the emotional bet had changed. Either accept a certain loss—having to move back home, tail between his legs—or take a small chance that he could pass. Ken was still operating in the Tversky-Kahneman mode; but, subtly, we had reconstructed the choice. What had felt like the safest option was now the most threatening.

  "I've got to start studying," Ken announced, his determination returning.

  "Absolutely!" I said, laughing. "You have to study every minute and drive yourself into the ground. You have to stop eating and stop sleeping. You have to so torture yourself with the fear of failure that you put yourself in a state where you can't learn!"

  "Or," my voice suddenly turned serious, "you can get back to being Ken and doing the things that have always worked for you. And if you fail, you fail. You won't be the first to fail a course. You'll take it over the summer, get it out of the way, and move on. It won't be fun, but it won't be a killer either. Summer in Burlington, New Orleans, or Chicago sure beats a summer at home, doesn't it?"

  Ken laughed. It was one of those transformations that make counseling so rewarding. At that moment, I had no doubt that Ken would find a way to pass. By redefining risk and reward, he had gone from bared throat to emboldened warrior in a matter of minutes.

  SHIFTING RISKS AND REWARDS IN TRADING

  Ken's therapy illustrates an important idea: It isn't necessary to change your personality to make major life changes. The challenge is to make your personality work for you, rather than against you.

  Ken came to counseling desperately wanting to not fail. He left counseling desperately wanting to not fail. Our meetings helped him redefine what failure was by translating his problem from one set of terms to another. And that, as you will see, is a crucial process in all psychological change. Every major change entails a change in perspective, a redefinition of risk and reward.

  Many traders express an interest in changing themselves instead of focusing on the specific patterns that they want to alter. They want to talk about their self-esteem, their troubled past, or their poor relationships. Such a problem focus simply reinforces their identities as troubled people. What traders are doing wrong—their impulsive overtrading, their fear of entering positions, their inconsistency in risk management—is looking to solutions that no longer work. Traders caught in such patterns are like Ken: They are managing their emotional distress rather than their current life challenges.

  Ken changed by viewing his former solution—avoiding work—as the greatest failure of all. He was achievement oriented to begin with, and we utilized this fact to leverage his emotional change. Once he viewed his old pattern as failure, he could make a 180-degree behavior shift without months and years of therapy.

  Similarly, traders tend to be achievement minded. They hate to lose. The key to change lies in the recognition that their impulsive or overcautious trading patterns entail the greatest losses of all because those patterns rob them of future as well as current success. Traders change when they leverage their achievement orientation as a solution, stop beating on themselves and endlessly analyzing their flaws, and make their problem patterns their greatest enemy.

  Emotionally troubled traders have defined themselves as the problem, and it is their achievement motivation that then drives them to turn on themselves. They are doing something good—trying to eradicate the problem! By identifying the old solutions that are no longer working and making those the problem, traders can stop the cycle of losing and beating themselves up; and, like Ken, they can use their motivation to fight the real enemy.

  But how can they sustain the fight against the enemy? How can they get to the point where they consistently turn their energy against the patterns that sabotage trading, rather than against themselves?

  The answer, oddly enough, can be found in music.

  MUSIC, MOODS, AND PIVOT CHORDS

  Music is never far away. Almost every movie has a soundtrack: the tubular bells casting a spell over The Exorcist, the brass fanfare of Rocky impelling the boxer's jog through the streets of Philadelphia, Vangelis's electronic soundscape following the runners through their paces in Chariots of Fire, the menacing, brooding sounds of the shark's advance in Jaws. It is difficult to think of these movies without their music. The melding of sight and sound generates a powerful set of memories.

  Advertisers realize this. They create vivid visual and musical images to accompany the presentation of their products. It is not enough to simply explain the virtues of a cola, a bar soap, or an automobile. Advertisers need to show laughing, happy people in a dizzying succession of images, accompanied by up-tempo music and an energetic announcer. In fact, many commercials say very little about their product. Instead, they show the product and link it to memorable images and sounds. The moods anchor the message, helping it stick in the consumer's mind.

  In days of old, soldiers marched to music. Now sports teams bring music to the locker room; their fans in the stadium absorb the rhythms of pep bands and sound systems. Boxers and wrestlers enter the ring to the sounds of their favorite, high-energy songs. There is musical accompaniment at funerals, religious services, and graduations. A crying baby is often calmed with a lullaby. Later in life, the sounds internalized, people hum and sing to themselves in the car or the shower. Lives are conducted to a musical score, proceeding to a beat and a rhythm that operate below usual human awareness. Music provides the moods, the emotional texture to many of life's messages.

  The therapist Moshe Talmon has referred to pivot chords in therapy: points at which a person's meanings can provide a transition to a new way of understanding and experiencing events. In music, a pivot chord is one that contains elements of several different keys, providing a natural transition to a new key. The point at which the pivot chord is struck is one of maximum ambiguity, as the score could proceed in any of several directions.

  Composers often sustain a sense of anticipation and drama by prolonging pivot chords, creati
ng a buildup of tension to be released in the subsequent key shift. Philip Glass's musical train in the soundtrack to Powaqaatsi is a persistent, intermittent pivot chord (the whistle) accompanied by short, repetitive sequences that capture the sense of motion. When the whistle finally resolves, the involved listener experiences the shift in a visceral manner, as a change. Talmon suggests that transition points in therapy—points of rapid change—have precisely this musical structure.

  TOM'S PIVOT CHORD

  Tom was a trader who came to a counseling session complaining of anxiety. His anxiety typically peaked early in the trading day and inhibited him from entering positions, despite unambiguous signals from his research. Through the day, he would then berate himself for having missed a golden opportunity in the morning. This only added to his agitation, which he then attempted to assuage with a late-day trade. This trade was often impulsively conceived and left him in the hole on a day when he should have been adding to his equity.

  All of this became a self-sustaining cycle, as missed opportunities and losses added to his nervousness, which then created further missed opportunities and impulsive trades. By the time he talked with me, he had run through a significant portion of his trading capital.

  He was noticeably tense in our conversation, his words running together in a frantic monologue: "I don't know why I am feeling so anxious. When I wake up, I feel this knot in my stomach. I'm all tense and knotted up. I immediately start thinking that it's going to be a bad day, that I'm going to crap out on my trades. Then, all day long, I feel nervous. I don't even want to go outside to take my dog for a walk. I don't want anything to upset me. I can't stand feeling this way. Yesterday, I was so worked up, I thought for sure I was going to give myself a stroke. My heart was racing and I thought I was making myself sick. But I couldn't stop it."