Wednesday, July 27, 2005

Once Burned, Twice Shy: Do brain-damaged traders really have an advantage over the rest of us?

When I first started trading, I made a lot of mistakes. After I'd made pretty much every mistake known to man, I started repeating them. It was pretty ugly for a while. At one point I realized that everyone else was committing the same errors, over and over, and there was a certain logic to it. The article below identifies the logic of one of those "hardwired" mistakes.

I first became acquainted with this investing mistake when I was trading off some market-forecasting software I'd developed. It seeemed like pretty sophisticated software at the time, but whenever I had a loss, I began to doubt it's efficacy. After a particularly brutal loss (like when I was long S&P futures during Alan Greenspan's "Irrational Exuberance" speech in 1996), I'd sit out the market for the next few days "to take a break". And it ALWAYS seemed that by sitting out the market, I'd miss the best trades of the year. We have a tendency to sit out the market after losses. It's an emotion-driven error, and we need to be especially careful about avoiding it.

A somewhat misleading Wall Street Journal article: "Lessons from the Brain-Damaged Investor" July 21, 2005 discusses research on people with a unique type of frontal brain-damage. The study was published in June's Psychological Science. In the study, people with a focal type of brain lesion, eliminating their ability to "feel" emotions, were pitted against "normals" in a gambling game.

In this experiment each participant was given $20 to start. Then they had the option of gambling or abstaining over twenty rounds of coin flips. If they chose to gamble, they would win $3.50 if the coin toss landed on heads or lose $1 if it came up tails. If they chose to abstain, then they made $1 automatically. The expected value of the gamble was $1.25, so you might assume that most subjects took the gamble.

Sure enough, normals took the gamble at an average rate of 68%, and brain-damaged subjects took it 78% of the time. After a loss, brain-damaged subjects took the gamble at the same rate (about 80%), but normals dropped to taking the gamble only 47% of the time. Because of a recent loss, normals became "irrationally risk-avoidant." So you might imagine, "there's a brain area that sabotages my investing."

This isn't quite true. It turns out that these brain damaged individuals can have pretty miserable lives - maxing out their credit cards, not showing up to work on time, falling for internet scams. Even though most of them score normally on psychological tests, there is clearly something wrong with their judgment. They can't seem to recognize the downside of risk, the possibility of loss. So they aren't necessarily an example of good investors. But there is something to be learned here.

The more relevant story, for most of us, is that we tend to avoid financial risk after a recent loss. Risk avoidance is pretty smart after most types of losses - that's how we learn from mistakes. For example, if the executives of a company you are invested in are caught "cooking the books", leading to a nasty price decline, then you might be more wary and do more due diligence before investing in a similar company. That caution is a good thing, because that's how we learn to avoid unhealthy risk.

The same type of avoidance happens among traders after personal losses, such as illnesses, broken relationships, or job changes. Traders may unexpectedly find themselves hesitant and with "difficulty pulling the trigger" when thinking about trades.

Problems often arise when we learn from "mistakes" that were actually random events. If we mistakenly believe that our investment results are due to factors within our control, then we may compulsively re-examine our strategies after losses, potentially leading to "analysis paralysis."

Recent losses make us afraid of taking on more risk. If we avoid the stock market entirely because we got burned by a few internet stocks, then we're not being rational, and we're missing out on higher returns down the road. Maybe this is why bear markets drag on, leaders talk about a "crisis of confidence", and most investors wait for price "confirmation" before jumping back in. Of course, waiting for confirmation means missing much of the price move, but that's the cost we're willing to pay for enhanced confidence.

What are the take-aways? After a loss, be careful that you don't over-analyze. if your strategy is well thought-out and tested, you've got nothing to worry about. Most likely, it was just random events taking place.


Friday, July 15, 2005

Here's a few predictions of which you can be equally confident:

1) The sun will rise tomorrow morning.

2) The Tampa Bay Devil Rays will fail spectacularly in their bid to win the 2005 World Series.

3) The return for individual investors in 2005 will be worse than the advertised returns for the funds in which they invest.

In other words, if at the end of the year a fund claims a 14% return, you can be certain that the actual return for the average investor will be less than that.

The Wall Street Journal, (7-13-05, "Fund Investors Gain by Sitting Tight", by Jane Kim) once again explains this unfortunate investing phenomenon, something I call "Whack-A-Mole Syndrome". It is the dominant paradigm of today's investor, as predictable as it is insidious.

Why does this happen? In short, because human emotions confound our buy/sell decisions. When we see a fund move higher, it becomes safer, more attractive. We buy in. When a fund slumps, we tend to feel uneasy and move our money elsewhere. The problem is that this pattern virtually assures that we will buy on the peaks and sell in the valleys.

Many 401 K plans unwittingly contribute to the problem. They ditch the funds that are underperforming (gotta get rid of those dogs!) and move to "hot funds" that are a lot easier to defend to the bosses and the employees.

Whack-A-Mole by proxy.

This recently happened to me. I checked an old retirement account with a former employer to find all new holdings and my balance inexplicably lower. I called the HR department. The exchange went something like this

Frank: "What happened to my funds?"

HR Guy: "We rotated out of those funds."

Frank: "Whyja do that?

HR Guy: "They were underperforming."

Frank: "Ah. I see... well thank goodness for that!"

HR Guy (Apparently immune to New York sarcasm): "Our pleasure, sir."

So how do you combat this monster in your accounts? The WSJ article gives some simple advice supported by data: Hold onto them longer. The longer an investor has the fund, the closer their return will be to the advertised return.

There's an old expression: All roads lead to Rome. Well in the investing world the expression would be, "most roads lead to wealth". The problem isn't that people get on the wrong road. We just have this awful tendency to wander off them.

Keep that in mind next time you feel like "taking a short cut".

Monday, July 11, 2005

Aspiring to Trading Greatness

What makes a great trader? In the 1983 movie "Trading Places," Eddie Murphy (a wily street con-artist) and Dan Akroyd (an ivy-league heir and investor) had their identities reversed by two wagering millionaires. Could Eddie Murphy, with no prior experience, succeed in the trading pits? Could Dan Akroyd pull himself out of forced homelessness with nothing but his own smarts? The comedic pair ultimately outwitted their interlopers and made a killing in "Frozen Orange Juice" futures. Yet the question those two devious millionaires gambled on remains unsolved, is it innate skill or life experience that makes a trader great?

Occasionally we work with traders. Sometimes we help them get out of a "slump". Sometimes they're already good, and we help them become great. Because of the high level of interest in what makes traders great, and the large amount of really poor information on the subject, I'm posting a list of the characteristics of great traders.

This list is a compilation of the results of academic research into the elements of trading success. Since these are academic studies, the results aren't necessary simple to understand, but it's the closest thing we've got to help us emulate the minds, if not the strategies, of great traders.

CLICK HERE for the trading success factors.