Tuesday, April 10, 2007

Countering Information Processing Biases In Trading

In a post a while back, I likened consciousness to a radio dial, with the various frequencies constituting our physical, cognitive, and emotional states. Powerful emotional experiences create very strong signals that dominate the radio spectrum, subsequently placing us in states that may interfere with our functioning. When those powerful experiences are positive, their dominance is crucial to the creation of addictive behavior patterns. When they are negative, their dominance is manifested as psychological trauma. One of the most important reasons for not trading too large for one's account size is the avoidance of roller-coaster emotional experiences. These lead to self-inflicted patterns of addiction and trauma that disrupt sound decision making.

On a smaller scale, markets create emotional experiences for traders each day. They do so with sudden large movements and shifts in volatility. Memory is not a democracy: not all memories are processed equally. We tend to place undue weight on what has occurred recently, and we tend to overweight emotional events. No doubt there are evolutionary reasons for these cognitive biases: cave man probably needed to focus on threats in the here and now to aid survival. The downside to this legacy is that, as traders, we can place more emphasis upon recent, emotional market events than is warranted by an objective look at market probabilities.

A great example of this is when we're stopped out of a good trade and then fail to take the next good trade because of fear of loss. Another example recently mentioned to me by an experienced, successful trader is getting excited by the recent volatility during the market decline and then overtrading the reduced volatility of the subsequent market bounce. I've been guilty of this myself: becoming so lulled by a slow, rangebound market that I take my attention from the screen and miss the subsequent, tradable breakout move.

Perhaps worst of all, recent emotional experience in markets can provide us with a negative edge in trading. I've written about short-term reversal effects in bull trends and bear trends: markets that have consistently risen over a multi-day period have yielded subnormal returns; those that have consistently declined have risen the most. When we overweight recent market experience, our thinking runs precisely counter to the market's own tendencies. Ever sold the exact low in a market or close to it? That's often a reason why.

I recently mentioned talking out loud as a way of changing our internal dialogues. If you follow my reasoning to this point, you'll see that talking out loud can also be a powerful technique for changing our biased thinking about recent market events. I suspect this is one reason many traders seek coaching: they're looking for someone to talk with to reprocess recent events and start with a relatively clean mental slate. But the efficacy is not in the coach, but the talking! In giving voice to our big picture market views and research, we consciously counteract any tendency to overweight recent market moves and P/L swings.

The same verbal recordings that can be helpful in rehearsing trade plans before trading and in reviewing performance after trading can be of help during market sessions--particularly when we make ourselves listen to what we've recorded. When we become the listener, we gain a measure of distance and objectivity with respect to our information processing. It is much easier to challenge a biased assumption when we hear it out loud than when we're identifying with it implicitly. The idea is to become a skilled observer of your own state shifts, so that you can consciously decide when to act upon them and when they are leading you astray. An audio trading journal can be a very helpful tool in developing this observing capacity.

6 comments:

Caravaggio said...

Nice post Brett, I agree it's important to be aware of this this cognitive bias, which manifests itself in many ways (eg: moving one's stop too early based on a price squiggle, exiting the trade too early, exiting a strategy too early following a run of bad results).

Side note: Barry Ritholtz (Big Picture) wrote on the same bias recently, but I think he may have got it a little wrong. He discussed how people may giving too much weight to the recent non-farm payrolls data. However, when it comes to macro trading, if we assume the equilibrium price reflects all information, then it is the marginal information that can create large shifts in price. Even if the landscape hasn't changed, marginal information can change the probable path of the future course of direction, and this can warrant significant price changes.

Dinosaur Trader said...

Brett,

Thanks for the post. I loved the line about memory not being a democracy, so very true!

Also, you'll have to help me convince my wife that talking out loud while trading is a good and not a bad thing.

She thinks I'm a little nuts.

Brett Steenbarger, Ph.D. said...

Great point, Caravaggio: the short term trader and the longer term investor may look at these bias effects differently. They may be tradable for the short term trader by going with the marginal information, but they may also be faded by the longer term participant, as assets deviate from proper pricing.

Brett

Brett Steenbarger, Ph.D. said...

Hi Dinosaur,

Actually I think you're right on the mark. Many people avoid talking to themselves out loud because it sounds crazy! So, instead, they keep their negative thoughts to themselves and thereby drive themselves crazy! Better to look nuts and keep a calm head about you than to look sane and go nuts inside... :-)

Brett

MarketProfessor said...

Very revealing Doc. I could particularly appreciate how recent emotional experience can provide a trader with a negative edge.

Traders' reasoning may go for a toss and he is forced by inner dialogue to take sub-optimal trades.This also relates to Traders TILT.My emotional balance has been devastated by recent shifts in Indian Stock market volatility induced by Central bank.

How to fight back after emotional devastation. How to reconcile after unforced errors? When we have deviated from our own rules. My old perspective I am unable to retrieve after particularly bad trades. Pl advise

Brett Steenbarger, Ph.D. said...

Hi Market Professor,

After a traumatic event--and large losses can be traumatizing for traders--the most important thing is to regain a sense of safety and control. Often I find that this means getting back to trading basics with small positions and regaining one's rhythm--not trying to get one's money back all at once.

Brett