Reference manual trading psychology

The London Academy of Trading Professional Financial Trading Programme -Course Reference Manual Behavioural Finance & Trading Psychology Page of 41 Behavioural Finance & Trading Psychology CONTENTS: OUR BEHAVIOUR MATTERS PEOPLE ARE NOT RATIONAL THIS COURSE: THE BRAIN IS NOT A COMPUTER A CAUTIONARY STORY - LONG TERM CAPITAL MANAGEMENT BEHAVIOURAL FINANCE HERD INSTINCT 10 DEFINITION OF HERD INSTINCT 10 BUBBLES IN FINANCE 10 SUCKER RALLY 10 OVERCONFIDENCE 11 BECOMING OVERCONFIDENT 11 THE ILLUSION OF KNOWLEDGE 12 THE ILLUSION OF CONTROL 13 Choice 13 Outcome of Sequence 13 Task Familiarity 13 Information 13 Active Involvement 14 OVERCONFIDENCE AND INVESTING 14 Overconfidence and Trade Frequency 14 Gender Differences 14 Trading Too Much 15 OVERCONFIDENCE AND RISK 15 OVERCONFIDENCE AND EXPERIENCE 15 WHAT I OWN IS BETTER 16 ENDOWMENT EFFECT 16 ENDOWMENT AND INVESTING 16 STATUS QUO BIAS 17 ATTACHMENT BIAS 17 Overcoming These Biases 17 SEEKING PRIDE AND AVOIDING REGRET (LOSS AVERSION) 18 DISPOSITION EFFECT (MORE LOSS AVERSION) 18 DO WE REALLY SELL WINNERS? 19 AVOIDING THE PAIN OF REGRET 19 DOUBLE OR NOTHING 19 Page of 41 HOUSE-MONEY EFFECT 19 SNAKE-BITE EFFECT 20 BREAK-EVEN EFFECT 20 THAT’S NOT THE WAY I REMEMBER IT 21 MEMORY AND INVESTMENT DECISIONS 21 COGNITIVE DISSONANCE 21 COGNITIVE DISSONANCE AND INVESTING 21 REFERENCE POINTS & ANCHORING 22 BEHAVIOURAL PATTERNS THAT SABOTAGE TRADERS 23 MOST TRADING PROBLEMS ARE VARIETIES OF PERFORMANCE ANXIETY 23 PERFORMANCE ANXIETY OCCURS AS MUCH DURING TIMES OF MARKET SUCCESS AS DURING TIMES 23 TRADERS COMMONLY TRY TO REPLACE NEGATIVE SELF-TALK WITH POSITIVE SELF-TALK DURING TRADING 23 PERFECTIONISM IS THE MOST COMMON SOURCE OF PERFORMANCE ANXIETY AMONG TRADERS 23 PERFECTIONISM LEADS TRADERS TO OVERTRADE 23 TRADERS THAT MASTER PERFORMANCE ANXIETY AT ONE LEVEL OF SIZE 23 TRADERS OFTEN THINK THEY HAVE WORSE PSYCHOLOGICAL PROBLEMS THAN THEY ACTUALLY HAVE 23 FOCUS ON PROCESS GOALS WHEN THINKING ABOUT TRADING, RATHER THAN PROFITS/LOSSES 25 TACKLE RISK INCREMENTALLY 25 STEP AWAY FROM THE SCREEN 25 USE MENTAL REHEARSALS TO MAKE THREATENING SITUATIONS FAMILIAR 25 ANCHOR MENTAL REHEARSALS TO DISTINCTIVE MIND STATES 25 PERFORM A MENTAL CHECKLIST BEFORE TRADING 25 GET A LIFE 25 HOW TO MANAGE RISK & UNCERTAINTY 27 STOP LOSS ORDERS 27 APPENDIX I 34 COLIN MCLEAN: HOW TO TELL A DUMB HERD FROM A SMART CROWD 34 APPENDIX II 36 COLIN MCLEAN: BEWARE THE ILLUSION OF KNOWLEDGE 36 APPENDIX III 38 BEHAVIOURAL FINANCE: WHAT DRIVES INSTITUTIONAL INVESTORS' DECISIONS? 38 APPENDIX IV 41 SHORT-TERM REACTIONS TO NEWS ANNOUNCEMENTS 41 Page of 41 Our Behaviour Matters Humans are prone to specific psychological biases – procrastination is one good example These can cause us to act in ways which are bad for our wealth Consider the following choices that we all face or have faced  Should I contribute to my pension plan now, or later?  Should I invest the extra that is in my savings account now or later?  Should I convert the Gilts and Bonds I inherited into stocks now or later? In every case the answer is the same – now The longer your money is invested, the larger your portfolio will be However the bias towards procrastination causes employees to delay making pension plans, often losing time, tax advantages and employer contributions People’s bias towards the status quo allows substantial money to build up in savings accounts before it is transferred into investments accounts; therefore losing the higher rate of return offered by an investment account We also have a bias towards keeping securities we inherited instead of investing them in vehicles which are more appropriate to our need This is called the endowment effect Not only does our psychology cause us to delay some actions, it can also cause us to act too soon and too often, and to our detriment in some cases In investing, sometimes we act too soon and sometimes delay too long Is this a paradox? Probably, but it is because we are human People are not rational Fundamental analysis, and much of people’s education and knowledge about investing and trading, is the work of financial economists from the world’s best universities However, these financial economists traditionally dismiss the idea that people’s own psychology can work against them when it comes to making good investment decisions In recent years, the field of finance has operated on two basic assumptions:  People make rational decisions  People are unbiased in their predictions about the future However, psychologists have known for some time that these are bad assumptions People often act in a surprisingly irrational manner and make predictable errors in their forecasts Economists are now realising that investors can be irrational Indeed, predictable errors of investors can even affect the functioning of the markets But most important to you the trader or investor, your reasoning errors affect your investing, and ultimately your wealth! I know that you could understand all the information in all the books on investment, and grasp all the hard fundamental data and still fail to make money if you let your psychological bias control your decisions This course:  Investigates many psychological biases that affect decision-making Page of 41  Will show you how these biases can affect your investment decisions  Will help you see how these decisions can reduce your wealth  Will show you how to recognise and avoid these decisions and avoid these biases in your daily lives  Will point out the investing tools which allow you to measure the psychological bias of the investing crowd, and to predict its behaviour One of the simplest and best known reasoning mistakes caused by the brain is visual illusion Consider this optical illusion Of the two horizontal lines, which is the longer? In fact, both lines are the same length Look again Although you know that the horizontal lines are equal in length, the bottom one still looks longer Just knowing about the illustration does not eliminate the illusion However, if you make a decision based on these lines, knowing that they look different lengths but also knowing they are in fact the same length; you will avoid making a mistake The brain is not a computer We say the brain is the most powerful computer there is but the brain does not act like a computer Indeed, it frequently processes information through short cuts and emotional filters to shorten analysis time The decisions made via this shorter route are often not the same as if the same decisions are fully analysed without these emotional filters These filters and shortcuts are psychological biases Knowing about these biases is a major step towards avoiding them One problem is overestimating the precision and importance of information Let’s play a game! (Here we have a questionnaire where we answer questions with 90% certainty) A Cautionary Story - Long Term Capital Management Even Nobel Prize winners in economics are prone to overestimating the precision of their knowledge Consider Long Term Capital Management (LTCM) The partners of the fund included John Meriweather, Salomon Brother’s famed bond trader; David Mullins, a former VP of the Federal Reserve Board; and Nobel prize winners Myron Scholes and Robert Merton The firm employed 24 people with Ph.D.s The hedge fund began in 1994 and enjoyed stellar returns In the beginning of 1998; LTCM had $94 billion in equity It had also borrowed $100 billion to leverage positions for higher returns Its original strategy was to find arbitrage opportunities in the bond market These low risk strategies were so highly geared the low returns were magnified into high returns After several years of terrific success, LTCM found it harder and harder to find arbitrage opportunities At that point the fund was forced into riskier positions to maintain returns As well as the compound effect improving performance, it compounded risk Page of 41 In August 1998, Russia devalued its currency and defaulted on some of its debt This action started a chain reaction of events over the next few weeks that led to devaluations in several emerging countries Bonds and stock markets around the world plunged There was heavy margin selling The prices of US Treasuries skyrocketed as investors fled to the safest investments These events caused the equity in LTCM’s portfolio to drop from $4 billion to $0.6 billion in one month The Federal Reserve was concerned over margin calls at LTCM which were threatening a systemic collapse of the financial system They quickly arranged for a consortium of leading investment houses to inject $3.5 billion into the fund in exchange for 90% of its equity How could a hedge fund with such human brainpower lose 90% of its equity in one month? In designing their models the fund’s masterminds did not think that so many things could go wrong at the same time Doesn’t this sound like their range of possible outcomes was too narrow? Page of 41 Behavioural Finance All people (even very smart ones) are affected by psychological biases Traditional finance (i.e Efficient Market Hypothesis or EMH) has considered this irrelevant It assumes people are rational and tells us how people should behave These ideas have brought us arbitrage theory, portfolio theory, asset pricing theory, option pricing models Alternatively, behavioural finance studies how people actually behave in a financial setting Specifically, it is the study of how psychology affects financial decisions Technical analysis is a set of tools to evaluate and predict the behaviour of the investing crowd Introduction Efficient Market Hypothesis (EMH) has been the theoretical foundation of the professional asset management industry and guiding light in the field of economics and finance for the past few decades Any findings that contradict it have usually been dismissed as statistical anomalies According to EMH, price movements follow a random walk, with changes in price induced by unforcastable ‘news’ about the underlying asset Consequently a trader would not be able to make money by looking at the freely available price history of an asset Any anomalies that did exist would be spotted and immediately corrected by the market The key word, hypothesis should be noted here We all know about the theory of gravity but we are also not all pinned down on the ground all the time You have probably heard the story of the fund manager and the academic, who were walking down the road The fund manager said, ‘Isn’t that a twenty pound note on the ground?’ ‘Can’t be’ said the academic ‘or else someone would have picked it up already.’ In recent years the pendulum has swung in favour of Adaptive Market Hypothesis (AMH) with more and more evidence of market predictability Contrary to classical Efficient Market Hypothesis, profit opportunities arise in modern liquid markets Researchers have long argued that perfectly efficient markets are not possible, for if a market is perfectly efficient, there is no profit earned by information gathering, in which case there would be little reason to trade and markets would collapse Critics outline that fundamental analysis is not flexible enough to take timely account of unexpected changes in the economic environment The effects of economic or political events often take effect with an unpredictable time lag As a result investors experience timing problems and it is due to these timing problems that people are increasingly turning to technical analysis For example according to Cutler, Poterba and Summers, 80% of the monthly price returns in S&P 500 index cannot be explained by macroeconomic news In addition, contrary to the trend towards higher market efficiency as predicted by EMH, market dynamics are much more complex, with cycles, trends, panics, bubbles and crashes and other phenomena that are routinely witnessed in natural market ecologies The search for theoretical explanation for the success of technical analysis has been a challenging one Increasingly the field of behavioural finance has been most successful in providing plausible explanations Page of 41 Behavioural Finance Psychology has not always played a central role in the discussion about the behaviour of market participants In the 1970’s for example, when EMH dominated academic thought, the human agent was described in non-human terms Under the efficient market paradigm, rational agents populate financial markets By ‘rational’ we mean normative Behaviour of market participants according to classical economic theory is said to be normative Normative theories are essentially concerned with how people ought to behave They are about rational choices, usually arrived at as a result of an optimisation process Anyone involved in investing – at any level - knows that this is not the case in real life and that investors’ behaviour - their individual hopes, fears, greed and emotions - have a significant influence on the movement of financial market prices Behavioural Finance has emerged over the last decade from a realisation by both academics and particularly practitioners that EMH and Arbitrage Pricing Theory not offer a good description of the capital market equilibrium nor they provide any account of the real behaviour of market participants or satisfactorily explain the development of securities prices and anomalies that occur Although the topic of behavioural finance is a broad topic, there are outlined below are some concepts involved in behavioural finance that provide theoretical justification for the success of technical analysis Conversely, the identification and analysis of trends and chart patterns with financial market instruments can be regarding as a graphical representation of this investor behaviour Confirmation Bias Once a decision or opinion has been formed, individuals are inclined to only consider information that supports their view, while ignoring or criticising information that is contrary to it Traders refer to this as ‘talking your book.’ As a result, if an opinion is gaining general acceptance, then it will be very difficult to get a contrary opinion accepted Thus the trend continues until the weight of contrary information is too overwhelming too ignore Selective Memory Human development requires an ability to forget terrible times so we can continue to function In financial terms, this may explain why humans fail to learn from past mistakes We convince ourselves that the future must be judged anew and that our current situation is special The technology bubble is a case in point: too many believed in a ‘new economy’ to justify stock overvaluations As a result of this repeated behaviour, cycles and patterns form Gamblers’ fallacy The gamblers’ fallacy is a belief that a trend must reserve, e.g if the roulette wheel has been black for so many goes, it must be red next It is essentially a misguided belief in reversion to the mean Reversals of lesser-scale corrections may be due to profit-taking or covering of losses, but it may be that humans have an inbuilt clock or sense of geometry that says when something just can’t go on Any these points may be described or explained by the likes of Gann, Fibonacci and Elliot Wave or oscillators such as RSI and stochastics Page of 41 Why does Technical Analysis work so well in FX Markets? Research on exchange rates has proven that technical analysis is useful for predicting short/medium term exchange rate dynamics and can generate significant profits It has been argued by some experts that in the short to medium term fundamental economic factors hardly have any effect at all on exchange rate dynamics Surveys of foreign exchange market participants consistently find that more emphasis is placed on technical analysis the shorter the time horizon Technical trading strategies such as momentum strategies have proven to be profitable in foreign exchange markets Researchers have proven that intervention actions of central banks create trends in exchange rates that can be exploited by technical traders The success of technical analysis in FX markets can also be explained by the dominance of ‘noise traders’, who make their trading decisions based on past directional movements The FX market is extremely sentiment driven and as a result trends are created from the changing mood of the market participants – sometimes traders interpret macroeconomic data one way then on another occasion another Long term economic pressures mean that trending behaviour is common in currency markets and within such trends the market level oscillates with changes in market consensus Continued oscillations of this type result in the formation of wave patterns within the underlying trend known as channels Trend following strategies such as moving averages are historically very successful at capturing trends in FX markets Long term trends tend to be displayed in currency pairs which are the exchange rates between disparate economies like EUR/USD and USD/JPY When analysing short term exchange rate dynamics, researchers have discovered clustering of orders Researchers have proven that exchange rates reverse course upon reaching round numbers more frequently than they reverse at other numbers, and that exchange rates tend to trend rapidly after crossing round numbers Take profit orders around these numbers tend to reflect trends, and stop-loss orders tend to intensify trends The clustering of execution rates at round numbers creates the support and resistance levels alluded to by technical analysts One research paper highlights that among support and resistance levels for currencies distributed by technical analysts to their customers, 96% end in or 5, and 20% end in 00 (Osler 2000) Summary Good technical analysts understand the importance of market psychology They observe the clashes between rival tribes at support and resistance levels They know that prices sometimes reflect solely the emotions of people in the marketplace and totally ignore the hard fundamentals They talk about the market being a ‘crowd’, like at a football match They are in this crowd Understanding the weakness and emotions of the crowd and their own weaknesses and emotions, and maximizing their strengths and discipline is the secret of trading success This course is a study of this and of the tool for understanding and profiting from it, Behavioural Finance Page of 41 Herd Instinct Definition of Herd Instinct A mentality characterized by a lack of individual decision-making or thoughtfulness, causing people to think and act in the same way as the majority of those around them In finance, a herd instinct would relate to instances in which individuals gravitate to the same or similar investments, based almost solely on the fact that many others are investing in those stocks The fear of regret of missing out on a good investment is often a driving force behind herd instinct Bubbles in Finance Also known as herding, such investor behaviour can often cause large, unsubstantiated rallies or selloffs, based on seemingly little fundamental evidence to justify either Herd instinct is the primary cause of bubbles in finance For example, many look at the dotcom bubble of the late 1990s and early 2000s as a prime example of the ramifications of herd instinct in the development of unsustainable trends Sucker Rally Definition: A temporary rise in a specific stock (or the market as a whole) which cannot be justified by positive fundamental information A sucker rally may continue just long enough for the “suckers” to get on board, after which the stock (or the market as a whole) falls back – often quite sharply A sucker rally is a rise in price that doesn’t reflect the true value of a stock It is also known as a "dead cat bounce" or a "bull trap” Example: Suppose that two high-tech companies, "A" and "B", see an increase in stock price due to reporting strong financial statements, and a separate high-tech, company "C," sees a rise in stock price If the real reason for the rally turns out to be because of potential acquisitions of A and B, then C will have had a sucker rally, rising along with A and B Page 10 of 41 How to Manage Risk & Uncertainty When NOT to trade: It is important to know when NOT to trade Tired Drunk High – caffeine, etc Angry Depressed/Low Classic trading and risk management rules: Have clear entry and exit signals - always know why you're entering and exiting a trade Have stop losses in place to cut your losses Have a plan to take profits along the way Diversify your trades - don't put all your eggs in one basket Be disciplined - write your trading plan down and stick to it Stop Loss Orders Stop loss orders ("stops") are limits set by traders at which they will automatically enter or exit trades - an order to buy or sell is placed in the market if price reaches a specified limit The first discipline that any trader should master is to always limit your losses A stop loss order is set to limit a trader's potential loss The stop loss is placed below the current price (to protect a long position) or above the current price (to protect a short position) Example: If you purchase 1,000 IBM at $90.00 you may decide to place a stop loss as follows:    SELL 1,000 IBM IF price is less than or equal to $87.00 If price falls to $87.00 your order will be activated Your loss is limited to $3.00 per share (plus brokerage) As a rule: avoid markets with low liquidity where extreme price fluctuations are possible Page 27 of 41 Emotional rules: Overcome your fear of risk Actively seek the truth and face it Remain flexible Focus on decisions not outcomes Be grateful for both donations and profits Overcome your fear of risk If you avoid taking risks because you are too fearful, that costs you opportunity As they say "Nothing ventured, nothing gained." And trading involves risk That's a fact So, how can you overcome your fear? The key is gaining a sense of self control There are main kinds of fear: a) Novelty fear - this is the fear of the unknown b) Irrational fear - otherwise known as 'phobia' Irrational fears are fears that are out of proportion to the actual threat being faced c) Rational fear - this is the kind of fear we should not be afraid of! This is the type of fear that is in proportion to the actual threat being faced If you learn more about what the risks actually are, then this helps you to overcome Novelty Fear since you conquer the unknown through knowledge Then, if you learn how to manage your risks intelligently, you can start to feel like you know what level of risk you're going to be willing to take in any given situation In other words, you can have an appropriate level of Rational Fear If you know the risks you're taking, and you take the protective measures you need in order to feel comfortable with that level of risk that's rational Now, when it comes to Irrational Fear well, mastering that can be a bit more tricky Some professional counselling can be a good idea in that kind of situation Irrational fears can often be addressed through Neuro-Linguistic programming (NLP), or using therapy techniques such as 'Systematic Desensitisation' or 'Flooding' With 'Systematic Desensitisation' you repeatedly expose yourself to the fear bit by bit in order to increase your level of tolerance to it So, experiencing little losses in the context of decent profits will help to reduce your sensitivity to the fear of loss With 'Flooding', you expose yourself to the fear to such a degree that the emotional response mechanism is 'flooded' and the irrational fear is disabled So, while big losses really hurt, if you keep on trading and find your way back into profit, subsequently the prospect of a big loss may not strike terror into your heart anymore Great traders all have to learn to live with and manage their fear They learn to refine their fear so that it ONLY consists of Rational Fear The best way to this is to learn to understand the risks better, discover your own comfort levels when it comes to taking risks, and trade within those boundaries But, what happens if you experience a big loss? FEAR can grip a lot of people who have experienced a loss They can get hesitant to get back into the saddle But if a trading opportunity is good then trade it! Because you won't trade your way back into profit by being reluctant to ever take a risk again Page 28 of 41 Take the lesson you learnt from losing the trade, and then trade again Analyse where you went wrong Take appropriate steps, adjust your process to try and make sure you won't make the same mistake again but keep on trading! Actively seek the truth and face it – be honest! If you put your head in the sand and avoid facing the reality of the risk and you have already exposed yourself to the trades you have already put on, and you hang onto the need to be RIGHT This is what usually causes the all-too common mistake of letting the losses get too deep before you cut them You know that famous question: 'Do you want to be right, or you want to be happy?' Well, the trading equivalent is: 'Do you want to be right, or you want to be profitable?' If you really want to be profitable, you need to let go of your need to be right In fact, even before you put a trade on, you should ask yourself this: 'What would be the warning signs if my view is not correct? What contra-indications should I be on the look-out for? What kind of movement, news, or information would indicate that I might be wrong?' Of course, your analysis to the best of your ability - in order to give yourself the best chance of being right BUT Once you have your trade on, always be questioning: 'Am I really right?' Instead of wilfully insisting 'I am right!' even when the market is telling you otherwise This is the kind of frame of mind, one of humility actually, that will allow you to see the light and cut your losses early on If you're not overly attached to your opinion, you'll give it up when the market tells you to Be willing to say: 'You know what? I don't really know what's going on here It's not making much sense to me.' And if that's the case, be honest with yourself about it and then: 'When in doubt, stay out.' Or 'If in doubt, get out!' This is not to say that you should panic and let go of your position every time the market has a whipsaw Not at all! Know your limits Know the level of risk you're comfortable with taking Stay within those boundaries You don't have to close the entire trade if you haven't reached your limit yet BUT if the jigsaw pieces are not making any sense, and you think what's going on might be a lot bigger than a whipsaw, then be willing to cut your losses early So you can live to trade another day Remember: in a fight between your opinion and the market the market is usually going to win! The market can remain illogical longer than you can often remain solvent! (Especially if you use a high degree of leverage) Remain flexible You never really KNOW which way a market will move You will have your opinion of course But you can't know for sure This is the essence of uncertainty So you have to be ready for anything Flexibility allows for greater adaptation and response to changing circumstances, especially during times of rapid change such as major market volatility Be willing to turn on a dime, if the situation calls for it, and perhaps abandon your long position and go short instead Page 29 of 41 Be willing to adapt to what is actually happening, instead of being attached to what you think should be happening Focus on decisions not outcomes People who display OUTCOME BIAS think they made a good decision when things turn out well, and a poor decision when things turn out badly BUT Isn't there such a thing as making a profit for the wrong reasons? I mean, gamblers it all the time A gambler might get lucky He might make a win occasionally But unless he has a rigorous process to his decision-making, he's probably not going to end up being profitable in the long run There are also times when you might everything right in terms of your analysis and decision making process, and it still doesn't work out Something random happens, it doesn't go your way, and you have to cut your losses Just because it didn't work out, doesn't mean the process by which you formed your opinion and made your decision was necessarily faulty - that decision-making process could still be profitable in the long run There are errors in logic that make overcoming OUTCOME BIAS harder: a) Recency Bias This is the tendency to weigh the most recent experience more heavily in our decisions than less recent experience For example, a bad recent trade can undermine our otherwise strong confidence in our decision-making process if we're not careful b) Belief in the Law of Small Numbers This is the tendency to place too much significance on a relatively small number of events within a larger context In other words, you start to second-guess your trading plan after only a couple of poor trades The problem is that you have to place a reasonable amount of trades to be able to really test your trading plan So if you want to gain confidence in your plan, you need to limit the size of your trades initially, so you can make more of them and repeat the process over and over Be Grateful for both donations and profits Just because a trade does not turn out the way you expected it to, doesn't necessarily mean that taking the trade was a mistake Even the best trading ideas or processes won't work every time The very presence of uncertainty guarantees that we will be wrong at least some of the time So be aware that losses are just part of the game You can't avoid them You can only minimise them Learn to view then as a learning experience, and as a necessary part of honing your trading skills Remember that it's not about being perfect, or even striving for perfection No The most important thing is actually discipline If you're a disciplined trader, you don't even necessarily have to be right more often than you're wrong Yes, that's right You can be WRONG more often than you are RIGHT and still be profitable! As long as you have the discipline to cut your losses short, to lock in some profits along the way, and leave a portion to ride on successful trades (when they come) to let some of the profits run if you can all that, then it IS possible to be wrong more often than you are right and still trade profitably Of course, it's easy to be grateful for your profits But be grateful for your donations too: LEARN from them USE them And, when it comes to your profits, beware of GREED Page 30 of 41 Greed will tell you not to take profits along the way - NO, NO, says greed: hold out for the mother load! The problem is, the market can turn on you any moment, and the profits you didn't lock in can be wiped out, and you can even end up in a loss situation It's always a good idea to take some profits along the way so that you are sure to get your initial investment back, as well as a decent profit Page 31 of 41 Summary Maybe you can now understand that there is more to investing than just making money It is an ongoing journey and transition process of acquiring new skills and improving them Sure, you could say that the same applies to golf, gardening or stamp collection but few other environments provide the magnified pressure cauldron such as the markets in which to execute learned mental skills under the pressure of losing money The pressure is self-induced by magnifying the perceived importance of money Perceived or not, when you mix people and money the pressure is on One of the most satisfying outcomes of providing trading methodologies to and coaching active investors for many years is the feedback that has been provided by many that have successfully transitioned their active investing paradigm Just about every person that comes to the markets does so to make more money, their primary motivation is growing their money However, when I have long discussions with customers that have become and then remained mechanical active investors for many years the most important things to them in hindsight is not the making of money through outperforming the market indices, the important things to them are: • overcoming fear through trust (in an edge), • creating investment processes and then surrendering to those processes, • accepting and being at peace with outcomes of individual trades through focussing on the process, • having no expectations for individual trades, • believing in probabilities and thereby overcoming the uncertainty of individual trades, • overcoming their biases that are harmful to investing in the markets, instilled through many years of living in society, • overcoming the “noise” that surrounds the markets propagated through newspapers, newsletters, TV shows, radio shows, advertising and many other sources These investors have learnt that you cannot trust and fear at the same time If you are fearing you are not trusting and if you are trusting you are not fearing There is more to it than just money The benefits of transitioning how you think, feel, say and go way beyond just making money Page 32 of 41 Bibliography Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the New Science of Behavioural Economics Gary Belsky (This offers an interesting & practical introduction) Inefficient Markets: An Introduction to Behavioural Finance (Clarendon Lectures in Economics) Andrei Shleifer (This book is more advanced and quite technical) Investment Madness: How Psychology Affects Your Investing… and What to Do About It John R Nofsinger (This is a relatively easy read) Page 33 of 41 Appendix I Colin McLean: how to tell a dumb herd from a smart crowd Sep 16, 2011 Big market falls and high volatility are too easily dismissed as mindless herd behaviour Might these moves actually be telling us something useful? Can we distinguish good crowd behaviour from bad? Behavioural finance offers some clues on how meaning might be extracted from the current market chaos It points us to examining the insights that are driving the price moves, rather than just calling it a blind panic The crowd might have spotted something that most analysts are missing If so, the August market lows could be revisited soon Surprisingly, it can make sense to pay attention to the crowd, even when it seems irrational The issue is not necessarily that other individuals may be smarter, but that someone else might spot a key change first Before the Dow’s August crash, a few observers questioned the July US consumer ‘rebound’, noting that car showrooms were still full of slow-moving stock Sell-offs deserve more than a mocking glance Cynics deride sell-offs Nobel laureate Paul Samuelson said that ‘Wall Street had predicted nine out of the last five recessions’ In fact, a new study by UBS has assessed the real predictive value of a fall of more than 17% in the S&P 500 Since World War II, the market was right nine times, five warnings were wrong, and another two recessions were simply not forecast However, the market’s recent record is much better, none of the mistakes happened in the last decade Market moves can predict the economy; the crowd often makes sense Some investors try too hard to ignore the crowd Last month, when the S&P 500 was down 11%, a poll of strategists showed they were as confident as ever about their end of year targets The average forecast was 17% higher It sounds robust, but we should question this, even though the fall and rebound was exactly what happened in 2010 The proximity of last year’s experience could be influencing strategists’ expectations Humans latch on to patterns, and this sort of repeat is the easiest forecast Some strategists even said they were not changing as a matter of policy, lest it be seen as a ‘reactive mind-set’ But there are times when it is right to respond to what others are doing Signals of new trends can come from surprising areas It could be easy for an individual, or even a single investment organisation, to miss these sources The challenge is to balance what one knows or believes against the possibility that the market might actually be capturing useful new information At the root of this summer’s market fall were new concerns: global growth prospects, Eurozone bank problems and the US budget Politics and macro-economics are poorly captured by analysts compared with company research August’s poor US data caught most analysts by surprise Page 34 of 41 The rational crowd Not all rapid market falls represent information cascades where the wrong signals are amplified In 2007, bank shares were weak technically, showing real fear despite confident reports from bank executives This persistent selling reflected concerns that were emerging from unconventional sources Yet the crowd picked up on the submerged information and ignored the buy recommendations Understanding crowd behaviour is an important aspect of behavioural finance and light has been shed on this from a surprising source Studies of social animals such as honey bees, fish shoals and ants highlight the conditions needed for smart crowds, rather than a herd mentality In effective crowds, individuals collect information independently, but are quick to pick up when another has better signals Following the crowd can be rational behaviour, particularly when new threats are emerging Research has shown that investors tend to place more importance on crowd wisdom than their own private judgement when the environment is moving fast This mirrors behaviour in the animal kingdom Swarms fleeing danger should follow the crowd 60% of the time, but spend the other 40% searching out their own escape routes It shows that we should pay some attention to what others are doing, even if we think we are smarter We should not be so quick to dismiss ‘herd mentality’ in a sell-off New information might be driving the adjustment to share prices Waiting for conventional sources to revise their outlook could mean missing the best chance to protect capital Page 35 of 41 Appendix II Colin McLean: beware the illusion of knowledge Investors start each year determined to better With hindsight, last year’s mistakes always look obvious – surely we can learn from them? The second half of 2011 was a dreadful period for small and mid-cap companies, hitting most actively managed portfolios Yet history repeats itself and, as with last year, the January effect has prevailed Smaller companies have beaten the FTSE 100 over the month, in a triumph of emotion over reality Given the poor long-term record of small caps, investors should have fallen out of love with the sector by now Can behavioural finance help us understand what is going on? The FTSE 100 Index has recovered to its levels of last summer, but smaller companies have lagged by more than 10% on average Mid-caps are only slightly better This underperformance is particularly disappointing, as it includes December and January, often the best months for smaller companies Poor outlook The longer-term picture is poor The small cap index is behind the FTSE 100 over 10 years; investors have not been rewarded for the higher level of risk involved Returns in small and mid-caps need to be better to recognise the additional research, dealing costs and lower liquidity This weakness in second-line stocks explains many managers’ disappointing performance last year Active portfolios are typically overweight in these stocks, with managers believing they have an edge in stock picking where companies are less intensively researched Growth expectations are also higher Behavioural finance recognises this failing as the illusion of knowledge – the belief that more information can boost returns Instead, it usually just increases confidence Investors can be distracted from looking at numbers objectively, instead paying too much attention to the language and enthusiasm of company management Information given in company meetings can also distract Too much weight can be given to the vividness of detail, which is difficult to verify or compare objectively between companies Analysis tends to focus on the apparent ‘uniqueness of potential’ in a company, rather than the background environment The impact of credit tightening is often overlooked, until managers get the call about an unexpected fund raising Recently there have been more of these nasty surprises This is a difficult stage in the business cycle, made worse by banks’ deleveraging Sustained recovery in the sector is likely to need M&A, a credit easing or a fall in sterling Smaller companies have most to lose from bank deleveraging, and are more exposed to a European recession Tight credit may also keep bids and mergers off the agenda Institutional investors are less enthused now about refinancing Funds with big stakes in small cap stocks are watching market liquidity drain away Stockbroking research is under pressure; lower market activity means less research and market-making And supporting share issues now could mean institutional investors becoming locked in Many funds need to demonstrate liquidity in portfolios If shares are not actively traded, managers may be forced to sell Page 36 of 41 Analysts often also show a bias towards optimism This time last year, growth of 17% was forecast for mid cap earnings for 2011 The actual outcome was 2% Earnings expectations for 2012 seem similarly unrealistic, looking for 20% growth Yet profit margins in small and mid-cap companies are already near historic highs How much further can they stretch? Too narrow a focus Undoubtedly, many smaller companies are well managed, but a good company might not be a good investment The danger is that fund managers focus too narrowly on results and forecasts and the challenging environment might not be factored into their calculations Small cap is a good story, easily sold to advisers and their clients The opportunity for growth and original research makes investors feel warmly about the sector But overall, smaller companies might not be worth the risk at this stage in the business cycle Investors should not let emotions get in the way of rational judgement – it is time to assess risk and reward realistically Colin McLean is managing director at SWM Asset Management Page 37 of 41 Appendix III Behavioural Finance: What Drives Institutional Investors' Decisions? By Franziska Scheven January 13, 2011 - It comes to nobody’s surprise that investors don't always make the right decisions When their stock picks go South, they are left with nothing but losses and regret Do these investors make wrong choices because they lack the necessary knowledge and expertise? Not necessarily In fact, what really keeps the investor from high stock returns is the investor himself, as Meir Statman, a behavioural economist, explains in his book “What Investors Really Want.” Personality, emotions, culture, gender and many more factors can keep an asset manager from making the rational and smart decisions that are needed to yield high returns, Statman says in a recent interview with Institutional Investor writer Franziska Scheven While institutional investors have a slight advantage over individual financiers because they act within a structure of an institution, such as a committee or a forum, and are therefore checked and balanced before taking action, Statman argues that both types of investors “tend to be overconfident.” A professor of Finance at the Leavey School of Business and the Santa Clara University, as well as Visiting Professor of Tilburg University in the Netherlands, Statman has long been attempting to understand how investors and managers make financial decisions and how these choices are reflected in financial markets The issues he addresses include cognitive errors, hindsight errors, emotions, aspirations, risk, fear and regret of investors and how these factors influence investors' decision making Institutional Investor: What can institutional investors discover about investor behaviour that would help them to make smarter, more rational decisions to achieve investment success? Statman: Asset managers know behaviour finance enough to protect themselves from their own errors But they use their knowledge of the errors of others to design products that people like, but short changed them in terms of return If individual investors, for example , think that it is easy to beat the market, then they are being offered mutual funds or a variety of derivatives that look like they have only gains and no risk attached Some of the issues that institutional investors face are similar to those of individual investors For example, institutional investors find it as difficult as individual investors to cut their losses and to realize them The difference, however, is that institutional investors are generally aware of their reluctance to realize losses and so they prepare themselves by creating structures within their company They are generally a step ahead in that they understand the kinds of cognitive errors and emotions that they face For example, traders might have a rule enforced by supervisors that all positions must be closed by the end of the trading day This way they cannot really hide losses and carry them day after day Would you explain how age, gender, genetics and personality affect investments? Page 38 of 41 We know that personality affects investors and how they make decisions There are people who are conscientious, who always come to meetings on time, have their paperwork set and not find themselves at a loss when it comes to filing their taxes Those people also tend to be more risk averse than other people They are more careful, but sometimes they get to be too cautious And there are people who are extroverts They enjoy the company of people and are talkative Those people tend to be willing to take more risks In my survey, it shows that men generally are willing to take more risks than women Men tend to be more overconfident than women Then there are differences across cultures People in China are more willing to take risk than people in the United States One possibility comes from culture In China, for example, investors can afford to take more risk because they have a structure of family that is going to support them when they fail There is more of a support system This enables them to venture out In the United States, it is much less so Countries like the United States are individualistic, and countries such as China are collectivistic It is also possible that differences have to with income per capita Incomes on average are lower in China than in the United States, so Chinese take risks because they have little to loose In the United States, people have more income so there are more severe consequences to loosing How can the lessons we have learned, specifically during the fiscal crisis, help us in the future? One of the elements is the effect of fear and emotions and how we make decisions Fear makes investors more risk averse and they stay away from stocks, like during the recent crisis Those who got out in late 2008 or early 2009 did not get back into buying stock in March 2009 and they well be still waiting This is because they are too afraid We also see the effect of how we think We tend to extrapolate from a recent trend Generally, after the market has gone up, investors think that it will continue to go up, and after it has gone down, people think it will continue to go down But this is wrong In this particular crisis, the vividness of the losses in 2008 and early 2009 is so great that even though the market has regained more than half of its losses, people are still shaken up At least retail investors still think that it is not safe to get back into stocks What role does emotion play in poor investing decisions? How can this be avoided? When investors look at investments, it is very much like when we look at the car – before we check for the things we are told we should check, like gas mileage and safety records – we just look at the car and say “it is beautiful” or “we would never drive it.” People approach investments in the same way, they look at Facebook and say "this is beautiful" and the future investment in Facebook would have high returns and low risks When investors like a stock, they think it will have both, high returns and low risks And when they hate it, they think it will have low returns and high risks This is the effect of emotions and one should know that and guard against it It's the same with the emotion of regret We buy a stock and when it goes down rather than up, we keep holding on to it anyway, rather than realizing a loss Page 39 of 41 This is because as long as we did not realize a loss, it is only on paper We still have hope that we are going to break even But when you sell the stock and realize the loss, this is also when you give up hope This is when the emotion of regret comes in and what makes it hard for people to accept the mistake and move on with their investment life Page 40 of 41 Appendix IV Short-Term Reactions to News Announcements Michel Dzielinski University of Zurich - Department of Banking and Finance September 16, 2011 Abstract: Analyzing a large database of US company news, evaluated with respect to their tone, I find significant differences in market reactions to earnings and other news While returns on days with earnings tend to drift, returns on other news days partially reverse within two weeks after the announcement This behaviour is consistent with the notion that investors overreact to salient but relatively uninformative information and under-react highly important fundamental news However, the tone of headlines does play a big role in how investors react to quantitative information as well Controlling for earnings surprise, the difference in earnings-day return can be as large as 6%, depending on whether headlines were positive or negative Taken together, these results suggest that qualitative communication merits close attention especially when it accompanies important quantitative announcements Page 41 of 41 ... markets at the time Trading when volatility is low, trading outside one’s trading plan or strengths, trading to make up a loss, and trading imprudently large sizes are examples of overtrading  Traders... excessive trading that can lower portfolio returns Overconfidence also leads to greater risk taking Trading volumes are increasing quickly, making traders and investors more overconfident Trading. .. This issue deals with memory reference points Initial purchase points are not necessarily the reference point, although they should be It appears that the most likely reference point is the best