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.


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