The Power of Conformity in Financial Markets - Candid Camera.

The following classic clip is from a 1962 episode of Candid Camera. This video captures a subtle point about human and crowd psychology which is commonplace in the financial markets.

Whilst it is amusing to watch, it's a good demonstration of scenarios commonplace in financial and commodity markets which has enormously powerful effects.

It is this force which creates trends and wild erratic movements in markets as tens of thousands of trades are placed in reaction to news, data,events and price action.

This immensely powerful force, has the ability to distract people and lead them astray from their well thought-out trading plans.



AlphaMind :Helping People Develop an Alpha Mindset for Optimum Performance in Financial Markets.

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Article by Steven Goldstein

Steven Goldstein is a leading Performance and Executive Coach and managing director at Alpha R Cubed Ltd.

Steven has worked as a coach with traders and investment professionals since 2009 with clients across the world. Steven's focus as a coach is on developing the 'Inner Game' aspects of trading performance.

Prior to becmoing Steven worked for more than 20 years as a traders in Rates and FX at some of the world’s leading investment banks.

See Steven's Full Profile.

Alpha R Cubed work with people and businesses in the financial markets to help them improve and develop behaviours to catalyse stronger and more effective risk performance. Alpha R Cubed run leadership development programmes, coaching programmes for leaders and financial market practitioners, and 'AlphaMind' Mindfitness Programmes.

If you are curious about how we could help you or your business, please email us at info@alpharcubed.com. or call +44 (0)7753 446097.

(c) Copyright AlphaRCubed Ltd, April 2019. Copyright in this blog and any accompanying document created by us is owned by us. Exception are stock images which have been acquired on license. Stephen Hwking image courtesy of Wikipedia.

Seminar: - ‘Developing Excellence in Trading and Investing Performance’

I am delighted to announce that I will be joining renowned market-timing expert Trevor Neil of Betagroup, to present a one-day seminar in Behavioural Finance and Trading Psychology from a neuro-behavioural perspective.

This cutting-edge seminar is aimed at traders, investors, portfolio managers and ‘heads of trading‘ desks and other risk professionals: The aim is to deepen understanding of the psychological, mental and behavioural forces which affect risk professionals and shape markets. It will also introduce behavioural practices and strategies which can help promote a significant edge in personal trading and investing performance.

The seminar will be held in Geneva on the 26th January 2012. Please see the link below for further details and how to book. This seminar is a joint-venture between Betagroup and BGT Edge.

http://www.betagroup.co.uk/Courses/geneva2012.pdf

Kind regards

Steven Goldstein (Group Owner)

Trader Performance Coach
BGT Edge – Enhancing Trader and Investor Performance
www.bgtedge.com
sgoldstein@bgtedge.com
Tel: +44 (0)207 993 5362 / +44 (0)775 344 6097

Cognitive Dissonance: Where traders start to dig holes for themselves.

‘Cognitive Dissonance’ is a theory which states that we like to seek consistency in our beliefs within our mind. If we hold two conflicting or opposing beliefs we get a feeling of discomfort or unease, as such we attempt to reduce this dissonance in our minds caused by holding these two conflicting beliefs. This dissonance reduction may involve us self-justifying or deceiving ourselves, this includes acquiring or inventing rationales which resolve this internal conflict, or modifying previous held beliefs.

As mentioned, dissonance reduction often takes the form of a self-justification of self-deception. Some examples of this occur all around us, smokers typically display cognitive dissonance, they know it is bad for them, and that it will probably shorten their life, but they’ll reduce the dissonance and justify the smoking by thinking ‘It’s not really as bad as they say otherwise it would be illegal’ or ‘I’ll worry about that when I’m older’, etc.  Dieters will also fall victim to this, they may justify having a chocolate or piece of cake by thinking ‘Its just one, what harm can that do?’ Last year in the UK there was a major scandal involving expenses fraud by Members of Parliament, whilst passing anti-fraud legislation, they had no issue with this contradiction, claiming their expenses were entitlements. Police will often continue to prosecute suspects whilst wilfully ignoring contradicting evidence. Academics have been known to doctor research evidence to suit their arguments, explaining this away by firmly stating their conviction in their beliefs.

Cognitive dissonance is all around us, and is often intertwined with other biases and behavioural traits. In a sense procrastination is only achievable because we enact dissonance reduction. E.g. ‘I’ll do that piece of work later, after all what’s the rush’.

So what and how does these affect traders and investors directly?

I’ll provide some simple examples.

Firstly, assume I have a long position in the SP500 Index future, say I bought some contracts at 1250. I then placed a protective stop at 1240 whilst looking for an upside target at 1280. I have a personal trading rule that I never move a stop further away once it is in place. – Later that day, the SP500 is trading down towards 1242, I sense that my stop is too tight and that this will bounce. I have a cognitive dissonance, my original belief was that if the market traded down to 1240, I was out of this trade, I was not prepared to risk any more on this trade, based off my initial analysis. Now I am thinking that this may trade lower and then bounce, however I will be stopped out before then. My dissonance here is that I need to remove my stop and place it at a lower level, but I never move stops once in place, this is a ‘golden trading rule’ for me. However, I decide in this case that I can break the rule on this one occasion, my though process is ‘just once it won’t hurt, I have a really good feeling about this’.

Hence I move the stop to 1230. The best thing that could happen in this case, is to get stopped out at 1230 immediately, as I would have instantly been penalised, and should thus learn the error of my ways. But assume that instead the SP500 drops to 1235, the stop is not triggered, and the SP500 bounces and rallies to my target. – I will feel that I was justified in moving my stop, and hence will be almost certainly giving me the green light to repeat that. Thus now a sensible rule, put in place as a form of discipline is jettisoned, and a slippery slope has been started, almost certainly with disastrous future consequences for my trading.

Another trading example shows how self-deceit rather than self-justification can be the dissonance reduction technique. In this example, assume that a trader was playing the USDJPY carry trade in 2007, and had decided to go long USDJPY on a break over 121, convinced that this was heading higher to 132 and maybe higher. His conviction is built on that the fact that this has been trending higher 2 years, is buoyed by the fact that he is gaining nearly 5% yield pickup on a daily basis, and is boosted by the knowledge that just about every major player is in on this trade. - Briefly the USDJPY rallies to 124, he is making money and feels good, all the stars seem in line, and in his head he is thinking of the future rewards this will bring. But from 124 the USDJPY declines and breaks a key level at 118. Now he is sitting on a loss, and looking at analysis which is indicating a major reversal is underway.

The problem for the trader, in this example, is that he has attached himself to this position; he had in a sense bonded and indentified with it. His evidence firmly suggested that a deeper reversal is underway, but he decides to label this a minor correction. This new analysis had created a cognitive dissonance for him; he resolved the dissonance by trivialising his normal rational analysis and invoking a self-deception; he decided that ‘this time it was different’. (There are a couple of other cognitive biases at play here, - The endowment effect; valuing an asset more highly when we own it, and the previously discussed confirmation bias). Eventually this trade would have suffered a huge loss, USDJPY declined sharply to below 100.   

The problem with ‘dissonance reduction’ techniques is the use of ‘justifying terms’ – such as ‘just once’, or ‘this time its different. Of course we never do something ‘just once’, in fact usually when we break a rule, we tend to repeat breaking it, particularly if we’ve justified it and been proved right on that occasion.

In the Carol Tavris and Elliot Aronson excellent book, ‘Mistakes were made (but not by me)’, they talk about how this process takes hold in the creation of corrupt police practices. A good young highly principled cop sees an older cop plant some evidence. He is angry, confused and conflicted, but the older cop says to him ‘We’re the good guys, these criminals are getting away with crimes that we know they are committing, isn’t it better that when we know something and can not prove it, we make it provable, its not like we do this regularly, but in this case its different, it’s a one-off.’  The young policeman decides to look the other way on this occasion, just once. – A couple of years later, this happens again, but having already justified it previously he convinces himself of the value of this. Eventually some years later, without a hint of conscience, he is repeating this behaviour himself. – He may not necessarily be a corrupt cop, he may be a good cop who has adopted some bad practices, but either way it is quite likely that innocent people are going to prison somewhere, and guilty people are out running free.

Cognitive dissonance can be the loose thread, which slowly pulled over time ends up destroying a whole fabric. In a trading/investing sense this is often what can happen; a sensible reliable trading approach can start to come undone, and as in the first example above, it is not the initial action, but rather what it implies, where the problem often starts. In the second example, the self-deceit can lead to a warped view of the market. From my own experiences working with traders, cognitive dissonance can lead to traders digging themselves deeper and deeper holes and by the time they realise what has happened it may be too late.

‘Recency Bias’ can distort our decision making and judgmental processes, thus reducing their effectiveness.

Recency bias is the tendency for traders and investors to give a greater weight to more recent trade performance, news and information, rather than taking into account older news, information and performance. This leads to distorted perceptions, decisions and judgments, and as such can seriously undermine overall performance sometimes with very negative results.

Here is a simplified example:

A trading method or system involves taking hundreds of trades per year. The hit rate is distributed fairly evenly, with more wins than losses, but with wins typically being three times the size of the average loss.

For example a typical run would look like this:

Win, Loss, Loss, Loss, Win, Loss, Loss, Loss, Loss, Win, Loss, Loss, Loss, Win, Loss, Loss, Win, Loss, Loss, Loss. 

(In summary 15 Losses, and 5 Wins: With wins performing three times better than losses the net effect is zero.)

Now compare it to this run:

Win, Win, Win, Win, Loss, Loss, Win, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss.

(In summary 15 Losses, and 5 Wins: With wins also performing three times better than losses, thus again the net effect is zero.)

Whilst the outcomes of the two run of trades are different, the trader may feel differently about his system or method at the end of the second run. The last 10 trades on the second run were all losses, whereas on the first run there were 3 wins out of 10, thus a fairly even distribution. Whilst this example is quite small the effect may nonetheless make the trader start to question his system or method: Is it still valid? Have the rules changed so much that he should alter the (proven) system or method? Should the trader take the next trade? Should the trader lower the risk level on his next trade? – I hope you can see where I am going on this.

In Curtis Faith’s excellent book, ‘The Way of the Turtle’, there is a great example of this: Faith provides a friend, who has begged him to reveal the secrets of his highly successful trading system, with all the details of the system. However the friend rather unfortunately decides to override the system following a string of losses. The relevant paragraph from the book is as follows:

‘Around February 1999 I (Faith) asked him how he was doing in cocoa since I had noticed that there was a great downward trend. He told me that he did not take the trade because he had lost so much trading cocoa and thought that the trade was too risky’. Curtis noted that prior to the downtrend starting there was a run of 17 losing trades. Collectively these losing trades added up to a loss of nearly $17,000. The subsequent 11 trades, which the trader did not take, contained 4 winning trades and 7 losing trades. The net result of these 11 trades was a profit of around $73,000.

It is worth noting that this ‘recency bias’, also occurs in the way we make many judgments, process information and review news. Investors may shun a share because its recent dividends were poor; however behind the scene the company may have made a significant investment in restructuring and producing new lines which will yield significant future results.

Another effect of recency bias is to alter our state of mind. There is nothing worse than a string of losses to dampen our enthusiasm. It may be that at this point we start to question ourselves and our ability, and that opens the door for self-doubt. Once self-doubt creeps in then we could fall into a viscous circle of doubt and crisis of confidence; we then start expecting poor outcomes, and once this starts happening we then actually then create them.

I would also like to add that though these examples focus on negative recency bias effects. However positive recency bias effects can also throw us out. – In the earlier example, a string of recent wins could have caused the opposite effect, making the trader less cautious and far too overconfident, thus leading them to take too much risk, with eventual disastrous consequences.

So what is happening for us to be affected by recency bias? – Well to one degree this is a natural occurrence, in the real world, recent events are much easier to recall. Our working memory, which is part of our conscious mind used for learning new activities, it has only limited resources, and as such is only able to hold a limited number of ideas and memories at any one time. As such older memories get put to the back of our mind, into our long-term memory: Whilst the storage in long-term memory is infinite, the ability to accurately recall this information and to have it at hand is difficult. Thus we have a much clearer recollection of recent events, and as such we end up with a distorted view of reality.

So what should one do to avoid the effects of ‘recency bias’?

1) Awareness of the problem is always the first step. – But rather like recency bias it-self, any memory you have of this article you are reading now is likely to be lost into your long-term memory before long, and will not easily be recalled. I would suggest make a note of this and other biases (Preferably in a journal), reminding your-self of how it may affect your trading and judgement. – It is essential to re-visit this periodically to remind yourself with regard to this and other biases and how they may affect your judgement.

2) Try and ‘develop a habit’ of tracking the record of your trades, or other relevant data you may be watching. – Here again a journal is highly valuable. – When you do hit an extended run of data or news, try and look back at it in perspective of the bigger picture.

3) Set-up rules, guidelines and criteria for trading and analysis. Check yourself regularly to ensure you are abiding by these criteria. Once again, our old friend the journal is an excellent place to note these rules, guidelines and criteria.

4)) Manage your-self: The more stressed and anxious one is, the more one is likely to veer from common-sense, and good practice. Euphoria, over-confidence, despair, self-doubt, and many other stated all have the ability to throw us off course, and lead us to abandon our usual work mode. Try and make obtaining and maintaining balance and perspective part of who you are and how you work. – Once again maintaining and reviewing a journal is an excellent tool to use as part of this process, along with a healthy life-style, exercise, work/home/social balance, etc.

We are as humans all prone to recency bias, however as traders, we have to ensure that somehow we do not let this affect our ability to perform and make sensible decisions and judgments.

Leverage – Your best friend but also your worst enemy.

The summary which follows is in response to work I have been doing with a recent coaching client. The client, no names mentioned, has given me permission to re-produce this short summary of one aspect of his issue.

The client, lets call him Bob, had been working for many years as an investment manager for a private investment house. His investments, though conservative, had always performed well, and his own private investment portfolio had also reflected his success at investing. He felt that given his knowledge and background that he would chance his arm at trading, though much more short-term, many of the principles involved were quite similar, and his investments had always been pretty short-term in nature. He had also been spread-bet trading for the past couple of years, with some decent results.

Thus he decided that the time was ripe for him to chance his arm at trading, the investment world had been good to him, but trading would give him a chance to magnify his performance through the use of leverage, which was not available to him when investing.

Unfortunately, after two barren years however, things had not been going well, in fact he deemed it a spectacular failure, and could not see anyway to turn it around. This was despite making some decent calls on the market, and his performance with his investments, which he has continued to do in the background though in very small size only, had remained solid.

Bob was put in touch with me through a mutual friend. After listening to Bob it was clear he had made one crucial mistake. He was misunderstanding the effect of leverage on his performance. Bob had set aside a trading pool of money of around £100,000. He was using leverage of 10 to 1. Thus this gave him a £1,000,000 trading fund. Bob was fully aware that a 10% hit would wipe him out, so he traded with a maximum drawdown of 2% of his trading fund (£20,000). This would of course wipe out 20% of his capital, and thus reduce his trading fund by 20%.

Bob’s trading style, which had its source in his investment approach, relied on leaving long stops, and holding trades for at least a few days. However, whereas before when he had placed a trade, he would remain calm, he was now fearful and slowly but surely this fear started driving his trading. On many occasions he would plan a trade and then do completely the opposite, he would end up taking small profits, and cutting losing trades before they hit the pre-defined stop, which sometimes they would never actually hit. Overall he was not sticking to his trading plan or his strategy.  

The source of the problem was in the level of leverage, but the problem had now taken on a psychological dimension. Bob was now fearful of trading, his fear had damaged his trading, his confidence was suffering and his self-belief was diminishing. This usually confident, bright and extremely clever person, had slowly got sucked into the fear/negative mindset/self-doubt loop.   

As a coach, I don’t tell someone how to trade, but I try to help facilitate a better or more appropriate approach. Typically the client possesses the solution themselves, almost certainly a better solution than I may come up with, however it is usually buried deep inside their mind, and due to their problems they are rarely clear-headed enough to be able to access it. Thus my job as coach is to help the client coax the solution of out of themself.

Bob, trusted his system and his approach, however he did not trust himself. His root cause of the distrust was his fear of losing too much to continue, this was driving his trading, and fear is such a strong emotion. At the core of this distrust was incongruence between his trading style/system, personality (Bob had a conservative nature and hated uncertainty) and the amount of leverage he was taking onboard.

Bob was adamant he was not going to change his approach and style, this had always worked for him, and it was what he knew. But he was aware that the leverage levels on a method which would require some potential hefty drawdowns meant he could not possibly continue as it was.  We went through a few scenarios, and although Bob was not originally in favour of this approach, he decided to try a nil leverage approach for a couple of weeks. In other words he would just trade his original capital. The idea at that point was more about restoring his self-confidence and breaking the negative loop cycle, than generating income. – After a slow start, Bob started making money, and after a month of this was feeling a lot better about himself. – After this he decided he would trade the second month on 2 times leverage, once again this worked out well, and Bob’s confidence was really being restored.

It is now 6 months since he first went back to nil leverage. Bob has had five very successful months, with one month suffering a slight drawdown, which he was very comfortable with. – He has been using 3x leverage the past 3 months, and is preparing to move to 4x, where he thinks the right level will be for him. – I will continue to coach Bob through this process. I do not know the right level of leverage; I think only the person trading can ever know that; it is a very personal thing. He has decided that 10x leverage is almost certainly going to be incompatible with his style and method. But that he was going to try and move to a higher level of leverage, find his comfort zone, and then slowly try and push that a little further.

I have used Bob’s example to highlight how excessive leverage can and does come back to affect you in other ways. Some people can cope with it better than others, and some trading system methods are better able to cope with leverage than others. I want to make one more point clear; this is real leverage here which is being talked about, trading capital verses real capital, and not margin risk, which is often many times higher.