Some good info from the latest Marcus Today newsletter. Things to consider ...
"Why do traders lose at trading? The answer is that they are humans not machines. Most traders are emotional, not clinical. You need to be clinical. But faced with losses, gains, luck and weakness that the studied professional works to squeeze out of the process. The stop losses in our trading section, the not negotiable stop losses are a good example. They add value and certainty and allow us to sleep at night (and there’s value in that).
Predicting the emotion of other people (exploiting them) is what behavioural finance is all about. There is a lot of stuff written about it but the exploitable bit is that over a large population and a significant period of time seemingly unpredictable emotions repeat, become predictable and can be exploited. For traders who understand this and trade against it it is like owning the “zero” on the roulette wheel. An edge that will manifest itself over time.
Here’s a list of some of the more common trading mindsets that cost you money, that are emotionally driven not logical. In financial (and social) theory some of these are called “cognitive biases”, erroneous rules of thumb or common errors of judgement. You might recognize a few of your own. They include:
Emotional bias – The tendency to believe the things that make you feel good and to disregard things that make you feel bad. In trading terms this means ignoring the bad news and focusing on the good news. It’s called losing objectivity. You don’t recognize when things go wrong because you don’t want to.
Expectation bias – The tendency to believe in things that you expect. In financial terms this means not bothering to analyse, test, measure or doubt the conclusion you expect or hope for. It is also known as the law of small numbers. Believing in something with little real evidence.
The Disposition effect – The tendency to cut your profits and let your losses run. The complete opposite of what a trader should be doing and what our stop losses allow in our TRADING PORTFOLIO section. Making small profits and big losses is a recipe for losses.
Loss aversion – The tendency to value the avoidance of loss more highly than the making of gain. Losses impact on you more than gains. Because of this you become more emotional when making losses, the point at which a rational decision would save you the most money.
The sunk cost fallacy – This is the tendency for our decision making to be influenced by the size of the loss we have already incurred. The bigger the loss the more likely we are to persist with a losing trade rather than take the rational decision to cut to a more profitable trade. The size of your loss has no impact on the future share price but a huge impact on your ability to make the right decision.
The Bandwagon effect – The tendency to think it must be right because everyone else is doing it. A thought process guaranteed to get you in when it’s obvious and get you out when it’s obvious. Put another way, it has you buying at the top and selling at the bottom.
Past price fixation – This is the tendency to avoid prudent trading decisions by anchoring your thought process to prices that no longer exist. “I’ll sell it if it gets back to what I paid for it”. What you paid for it is irrelevant to the future price and the current trend. I have had clients that used to say “Telstra owes me $25,000”. Well who cares, its worth $20,000, the future price doesn’t care what it owes you.
Without realising it all of us are prone to believe what we want to hear and reject what we don't want to hear. In investment terms this is a pretty important mental weakness we all possess, often unknowingly. It means that if new information is highly representative of our existing beliefs we will readily accept it. If new information conflicts with our existing beliefs we are less ready to accept it.
In other words if we already hold a stock we readily accept any good news.
Bias creates and prolongs momentum. If you buy early it is comforting to know that everyone wants to believe and promote the good news and will be slow to accept or broadcast the bad news.
It also means you have to be pretty clinical with information. A few obvious alerts are:
Do you or the information provider hold stock. Has your brain gone soft on the stock. And even if an information provider (an analyst) declares his bias it doesn't mean he isn't biased. Truth is he may not recognize his own bias. With a positive bias you should assess bad news more seriously because you are prone to ignore it, whilst someone more objective doesn't...and moves the price.
Although bias may seem to be a short term effect you should know that long term collective bias can and does exist. It happens when the whole market believes the same thing. Examples of collective bias that may not have paid off in the last few years include:
The banks are good investments.
Woolworths is a safe stock.
The resources boom will go on for decades.
And in the last few months:
Interest rates and inflation are going to zero for a decade.
Cognitive bias has some value in that it smoothes prices. When the whole market is biased the theme is unlikely to reverse quickly. So you are safe investing in a collective bias although there is a lot of money to be made spotting a change in a collective bias. But how do you do that? Easy to suggest hard to effect. The only obvious lesson is this. Recognize your own bias and pay more attention to any information that challenges it.
Bias is also interestingly used as a powerful subterfuge in negotiation, in particular when you want to endear yourself to someone. It is included as an exploitable commodity in office politics (I once went on a course). Because everyone is biased to think they are right, clever, good looking, a winner, whatever...you can use that. Just tell them what they want to hear. They will readily believe you and love you for it. Any bad news, just send in your competitor, sorry work colleague, with the news. Office politics 101. Blow smoke...
It’s not easy to be unemotional when trading, but that’s how we’re all wired. In order to be part of the winning minority we all have to un-plug and reconfigure. Systemise. Develop a process. Not rely on the seat of our pants. As I say, one of the best, most available and easy to understand methods of systemizing your trading rather than letting the seat of your pants dictate is stop losses. But they are just one part of a large body of work on trading. More on that next ‘Education Thursday'."
The bigger the loss the more likely we are to persist with a losing trade rather than take the rational decision to cut to a more profitable trade. The size of your loss has no impact on the future share price but a huge impact on your ability to make the right decision.
