A few weeks ago I gave a presentation to the STA (Society of Technical Analysts) talking about Trader Risk Personality, how we assess this using the 'Risk Type Compass' tool, and how 'Risk Personality' ultimately affects Trader Performance. Please click the rather unflattering image of me below, or the link below that to view this webinar.
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'Behavioural Performance Coaching Programme'. This powerful programme is used by many leading Hedge
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Click here to view _____________________________________________________________________________
Steven Goldstein is a
leading Performance and Executive Coach working with Traders, Banks, Energy Firms and
Hedge funds: He is Managing Director of at Alpha R Cubed, which works
with banks and investment firms to improve their human capital within
financial risk businesses. To know more about Alpha R Cubed, visit their
website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven on Twitter and Linkedin.
Cognitive Dissonance is a Human Behavioural Bias which can distort our thinking and perception in ways which can be highly detrimental to the performance of individuals and groups. This article highlights how this can have serious impacts on the performance of traders and investment professionals. However the lessons from this are applicable well beyond the world of finance.
Dennis Gartman states that ‘Capital comes in two varieties, mental and that which is in your pocket, and that of the two 'mental' is the most important and most expensive’. Mental capital is so difficult to control and manage because our minds do not work in the way we like to think they do. In a perfect scenario, they would work to make rational and sound decisions, with pros and cons perfectly weighed up, and outcomes considered objectively. However, reality is very different: Markets are volatile and uncertain, which restricts our ability to act rationally, and our minds are easily swayed by factors which heavily influence the way we think, decide and act. The field of behavioural finance looks to provide greater understanding of how these factors impact our decision making, affects our actions, and shapes our behaviours. A major area of interest for Behavioural Finance is human biases, one of the most impactful of these biases is 'Cognitive Dissonance', a term which is best summed up as how we cope when faced with 'Inconvenient truths'.
People will go to great lengths to avoid admitting an inconvenient truth.
As humans we seek rational explanations based on reason. We seek clarity, certainty, and logical solutions to difficult problems. This mindset is extremely challenged however in financial markets. Whilst there is an order to financial markets, this order is typically only discernible retrospectively. Financial markets are an example of a 'complex system': Complex systems are characterized by high uncertainty, volatility and non-constant variables. In a complex system, cause and effect are only clear with the benefit of hindsight. Contrast this to a 'complicated' system which is more static, and where sensing and analysis makes it possible to discern and find definitive solutions, often with application of scientificprinciples. Most people have been conditioned to work in 'complicated system', we have been primed this way by our education system and culture. However, the approach for a ‘complicated system', often falls short when faced with the uncertainty of financial markets. The diagram below emphasises this point:
It is within this 'complex' world of trading and investment, where people are seeking certainty and logical solutions, that mental biases can easily distort thinking and perceptions. 'Cognitive Dissonance’ is one of the most pernicious of these biases, and can have deadly consequences for performance in ways which impact short-term thinking and long-term behaviour.
Cognitive Dissonance occurs when we find ourselves compromised by an 'inconvenient truth'. I.e. The market maybe going lower, but we continue to believe in a bullish case long after the bullish case was proved wrong. Sharing opposing beliefs at the same time is mentally troubling and make us feel extremely uncomfortable. When faced with these opposing beliefs in our mind, we may create far-reaching justifications and rationalisations in order to avoid the discomfort connected to ‘Cognitive Dissonance’. Typically, we come down on the side of our initial or invested belief, only changing sides, if at all, when there is overwhelming evidence against us. Think of the classic trading mistake of refusing to cut-out a short-term trade, which then becomes a long-term trade. You didn’t start with a strong long-term conviction, but the short-term trade went horribly wrong and you decided to hold it. You are now faced with two opposing beliefs:
Belief 1) No convincing long-term view.
Belief 2) By running this short-term position as a long-term position it should make money.
Action taken to resolve this dissonance: The right thing would have been to cut the short position andtake a loss. But your 'loss aversion’ bias has caused you to avoid that action. Now with these two opposing beliefs you seek resolution of the dissonance. You do this by finding justification in calling this a long-term trade. This post-hoc rationalization is probably no better than tossing a coin, and often worse, as the market is already against you. These rationalisations now cause your perception to become more skewed. You start seeking news you want to see and ignoring the news you don’t. ‘Confirmation bias' now distorts your perception further. The path to losing more money than you ever anticipated on this trade is set. - Even worse, and possibly more damaging for your future, is the possibility this works out well!!! For now you will repeat this behaviour, and may even become part of the way you work. However, this behaviour is in direct opposition to every bit of sound trading advice (See Dennis Gartmans rules of trading). Over time, it will lead to more large losses than your account can handle. -This all came around because you could not face the inconvenient truth 'that you were wrong'. The irony being, that 'being wrong' is just part of life in a complex world of high uncertainty.
Cognitive dissonance seriously impacts performance in more ways than you realise. One of my coaching clients provided an excellent recent example of the damage ‘Cognitive Dissonance’ can reap. At the start of this year he turned bearish on stocks. He bought puts in the SP500, and also sold the DAX heavily. Within a few days he looked as if he was on the way to some decent profits. However, the market turned sharply, and went on a long bullish run, the trader however continued to fight this bullish move and his early year gains soon gave way to early year losses. It was now that his 'Cognitive Dissonance' started to come into play, his bearish view was maintained even as the market clearly showed bullish short-term sentiment. To add to the pain, two of his colleagues defected to the bull-side. He was now scampering around trying to find justifications for why he maintained the short trade. These justifications slowly become more desperate, he recalled himself thinking and saying that he was 'more convinced than ever that the market is wrong'. - All the time, in the cruel world that is trading, his losses were growing. Eventually the pain got too much and he pulled the plug on the short trade. - This is what 'Cognitive Dissonance' does, it can divorce one from reality, and force them to start defending their ego and pride at the cost of objectivity. - No one is immune from getting caught in this sort of trap, this trader was nonovice but a senior 'Portfolio manager' at a major hedge fund. To his credit, he recognized this afterwards and when we discussed it in a coaching session he was able to exorcise the ghost of this trade from his psyche.
Whilst this highlights how Cognitive Dissonance impacts trading performance directly, there is a far more devastating indirect element to 'Cognitive Dissonance' which can cause irrevocable long-term harm: Cognitive Dissonance can stop people from learning, and keep them in a 'closed loop' which leads to habitual repetition of mistakes and errors. This can become all the more insidious the more mature one gets. During a trader’s formative years, they are likely to have managers and mentors who point out their faults. However, as traders mature, they are less likely to get this feedback and support. Without this third party perspective, it can become incredibly difficult for people to recognize when they face a 'Cognitive Dissonance', let alone to resolve it in a balanced and objective way. In the above example, the Hedge Fund Portfolio Manager recalled a number of occasions over the years, where he has been stubborn and obstinate in the face of overwhelming evidence that he was wrong. I can also reflect on my own trading within my 25-year career trading FX and rates. There was a dark time in the mid-1990s where I kind of lost my way. I recall a number of similar trading experiences to the example above, perhaps it was not a surprise that my confidence suffered for a couple of years after those experiences.
Cognitive Dissonance Can Kill Your Performance and Potentially Your Career.
The term 'Killer Biases' may sound a catchy title for an article which gets people's attention, however certain biases can literally kill a career, a company (Kodak), and even people. 'The Semmelweis Reflex' is a term which describes the tendency to reject new evidence or new knowledge because it contradicts established beliefs. It was coined after the story of Ignaz Semmelweis, a Hungarian Doctor working in the Vienna General Hospital in the 19th Century. Semmelweis found that mortality rates of women giving birth dropped ten-fold when doctors washed their hands with a chlorine solution between patients and after autopsies. He tried to spread word of his discovery throughout the European medical profession, however his advice was rejected by fellow doctors who refused to believe that their own negligence may have something to do with the death of patients in their care. As a result many thousands of women continued to die needlessly for many years to come. Carol Tavris, and Elliot Aronson, cover this topic far more broadly in a brilliant book, 'Mistakes were Made (but not by me)'.
Click on the above advert to
find out more about the exceptional Alpha R Cubed
'Behavioural Performance Coaching Programme'. This powerful programme is used by many leading Hedge
Funds and Investment Banks to help develop and improve their peoples risk taking capabilities. Alternatively email info@alpharcubed.com.
__________________________________________________________________________________ Developing superior 'Cognitive Skills and 'Better Behavioural Practices' is the antidote!
It is incredibly difficult to know when you are in a situation where ‘Cognitive dissonance’ is occurring. Daniel Kahneman calls it correctly when he says “We're blind to our blindness. We have very little idea of how little we know. We're not designed to.”
The best way to avoid ‘Cognitive dissonance’ is to preempt it by developing better behavioural practices. This may not stop every single occurrence of cognitive dissonance, but it can certainly reduce, limit and mitigate the damage. In my recent article, 'The 10 Major Behavioural Traits of Highly Successful Traders ', trait number 5 emphasized 'Humility and Humbleness': Humble traders are less likely to fall victim to their ‘Ego’, and thus less likely to be seriously impacted by ‘Cognitive Dissonance’. __________________________________________________________________________________
Click here to view __________________________________________________________________________________
Everyone is capable of displaying 'Cognitive Dissonance', it is part of
our human operating system, however certain people are able to manage or
avoid it far better than others. These people are 'Behavioural
Masters'. Behavioural Mastery is vital for successful trading, probably
more so than any system, product, analytical tool or service, yet is so
undervalued in terms of people's priorities. People may
think the likes of Warren Buffet, Paul Tudor-Jones, Ray Dalio, have
some super source of informational advantage, however every bit of
information they get is available to the rest of the world. The
difference is that these people are 'Behavioural Masters', they execute
everything that they do a little better and a little smarter. As such
they create a behavioural edge. Buffet has his long-term philosophy
built around his own specific temperament. Paul Tudor Jones perfected
the art of strict discipline and Money Management. Whilst Ray Dalio
built his business around his key core principles.
Our own work at Alpha R Cubed has demonstrated how developing people’s cognitive and behavioural abilities can make a huge difference to their performance. Our coaching and consulting helps people and teams to leverage their behavioural strengths and develop superior cognition to improve how they engage with risk and monetise the uncertainty within financial markets. The table below highlights some examples of how this can help make a huge difference to performance. These are just some examples from bank and hedge fund clients where performance improvements have contributed to multi-million dollar improvements in performance.
These numbers only tell part of the story, client feedback tells another. The following is a from Simon Horwood, formerly Co-Head of Trading for Global FX and Short-Term Rates at Credit Suisse. It is part of a response to an internal inquiry about the coaching's effectiveness:
"Why I feel this has been successful, are the performances of traders that have been under the programmes tutelage. Now obviously improved market conditions have played a part, as well as luck etc. But one trader who has refused to take part in the 'coaching' has turned out to be the lowest revenue producer for the past two years having been consistently the highest for the previous five. Also, all the individuals that have taken part have become easier to manage, show greater teamwork and just appear to be happier overall. The positive impact on the group has been profound."
Wrap Up.
Cognitive Dissonance doesn’t just affect individuals, it comes to affect teams, group, companies even whole industries and professions even. It is a pernicious bias which operates largely ‘under the radar’ and beyond ‘consciousness’ within our human operating system. Only by developing superior thinking and behavioural skills, and reflective processes, will one be able to reduce the damaging and affect this can have on performance and outcomes.
________________________
Steven Goldstein is a
leading Performance and Executive Coach working with Traders, Banks, Energy Firms and
Hedge funds: He is Managing Director of at Alpha R Cubed, which works
with banks and investment firms to improve their human capital within
financial risk businesses. To know more about Alpha R Cubed, visit their
website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven on Twitter and Linkedin.
1. Never, Under Any Circumstance Add To A Losing Position.... EVER, EVER! To do otherwise will eventually and absolutely lead to
ruin! - Just to add a little extra emphasis, you will occasionally
break this rule, and it will seem OK, it may even go right several
times, but there is one time it won’t, and that time could kill you. – Remember ‘You only die once’. 2.
Trade Like A Mercenary Guerrilla: You must fight on the winning side and
be willing to change sides readily when one side has gained the upper
hand. There is nothing wrong with switching from bullish to bearish and
vice-versa, there is everything wrong with being obstinate and stubborn. 3.
Capital Comes In Two Varieties: Mental And That Which Is In Your Pocket
Or Account: Of the two types of capital, the mental is the more
important and expensive of the two. Risk Management is vital, but at
least equal is self-management; learn to walk-away, ‘you can always
fight another day’. Holding to losing positions costs measurable sums
of actual capital, but it costs immeasurable sums of mental capital. 4.
The Objective Is Not To Buy Low And Sell High, But To Buy High And Sell Higher: We can never know what price is the 'low', nor can we know what
price is the 'high'. Do not be afraid to buy what you worry may be a top,
it may soon be a long way from being the top. This is a check on
worrying about looking stupid, in truth ‘no one else really cares’,
remember that! 5. In Bull Markets We Can Only Be Long Or
Neutral, And In Bear Markets We Can Only Be Short Or Neutral. That may
seem self-evident; it is not, and it is a lesson learned too late by far
too many. Fighting trends saps a lot of mental energy, see 3 above. [Note: There should be an exception to this rule for dedicated contrarians, they are anticipating the ends of trends.] 6. Markets Can Remain Illogical Far Longer Than You Or I Can Remain Solvent: Courtesy of the inimitable John Maynard Keynes. - We like to
believe the market is full of people making rational logical decisions,
think again most of them are reacting to emotional impulses. See our
‘Chimp Paradox article’ for further elaboration. ______________________________________________________________________________
Beyond the Hype: The 10 Behavioural Traits of Highly Successful Traders.
Read the article Here _____________________________________________________________________________ 7.
Sell Markets That Show The Greatest Weakness, Buy Those That Show
The Greatest Strength. Metaphorically, when bearish, throw your rocks
into the wettest paper sack, for they break most readily. In bull
markets, we need to ride upon the strongest winds... they shall carry us
higher than shall lesser ones. (Such good advice, but so rarely
heeded.) 8. Trading Runs In Cycles: Some Good, Most Bad: Trade
large and aggressively when trading well; trade small and modestly when
trading poorly. In "good times," even errors are profitable; in "bad
times" even the most well researched trades go awry. 9. To Trade Successfully, Think Like A Fundamentalist; Trade Like A Technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technical’s. When we do, then, and only then, can we or should we, trade. (Personally, I don’t fully subscribe fully to this one, but then who am I to question it.)
10. Keep Your Systems Simple.KYSS: Complicated systems breed confusion; simplicity breeds elegance. In other words, ‘Less is often more’, and ‘Simplicity is beauty’
To find out more about participating in the exceptional Alpha R Cubed 'Behavioural Performance Coaching Programme', used by leading Hedge Funds and Investment Banks, email info@alpharcubed.com.
11. An Understanding Of Mass Psychology Is Often More Important Than An Understanding Of Economics. Markets are driven by human beings making human errors and also making super-human insights. Refer again to the ‘Chimp Paradox' article, markets are not being moved by thousands of Dr Spocks, but rather by the impulsive whims of herding mammals and battling tribes.
12. Bear Markets Are More Violent Than Are Bull Markets And So Also Are Their Retracements: In a bear market everyone flees for the exit at the same time, liquidity is not guaranteed in these times.
13. Be Patient With Winning Trades; Be Enormously Impatient With Losing Trades: Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large. (Advice as old as the markets themselves. - Heed it)
14. The Market Is The Sum Total Of The Wisdom And The Ignorance Of All Of Those Who Deal In It; And We Dare Not Argue With The Market's Wisdom. If we learn nothing more than this we've learned much indeed. In other words, ‘the market is always right’, it is never wrong, but you are, often.
15. Do More Of That Which Is Working And Less Of That Which Is Not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold. A variation on points 4 and 7 with an added twist, just shows how important this is.
16. The Hard Trade Is The Right Trade: If It Is Easy To Sell, Don't; And If It Is Easy To Buy, Don't: Do the trade that is hard to do and that which the crowd finds objectionable. If you are buying, and everyone else is long and buying, then soon who will be left to buy, there is probably not much upside left: This takes skill to get right.
17. 'There Is Never One Cockroach!’ This is a late addition to Gartman’s timeless rules. – I love this phrase, write it down somewhere visible and keep reminding yourself about this.
Good luck. Trading is never easy, only very few make it through boot camp. If they have its likely they have adhered too many of these rules. There is one other rule however, which every great trader somehow manages to achieve: I don’t recommend trying it until you are way past bootcamp. It is this one: ALL RULES ARE MEANT TO BE BROKEN: But they are to be broken only rarely and true genius comes with knowing when, where and why!
_________________
Steven Goldstein is a
leading Performance and Executive Coach working with Traders, Banks and
Hedge funds: He is Managing Director of at Alpha R Cubed, which works
with banks and investment firms to improve their human capital within
financial risk businesses. To know more about Alpha R Cubed, visit their
website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven on Twitter and Linkedin. Join the flourishing LinkedIn group Trader, Trading & Risk Psychology.
I love this clip from the classic 1960’s TV show ‘Candid
Camera’. It rather amusingly emphasizes the way we as humans are prone to conform to crowd behaviour.
There are many reasons for this, and it’s helpful to understand
these when we try to understand markets, and our own behaviour within markets.
We all like to think we are independent thinkers basing our decisions on sound logical and rational choices. - However, this is not really how the real world works. - I am minded of a hedge fund client last year who lost a lot of money when the Swiss National Bank surprisingly devalued the Swiss Franc against the Euro. - He had actually wanted to be short of the Swiss Franc, which would have made him a lot of money, but instead was heavily influenced by the fact that all the senior portfolio managers around him, and the head of the firm, were the other way around. Thus he overruled his own analysis, and went with their view. Which subsequently came at a heavy price. - For those who have never experienced life in a trading room, this is far more common than you think.
The Keynesian Beauty Contest
No matter how much we know, we are actually quite limited in our
knowledge, and we know that, but only at a subconscious level: In
financial markets, we can only ever have partial knowledge of all the
relevant facts, thus 'subconsciously' we assume the crowd has far more
knowledge collectively than us, and thus take notice of what they think.
As a consequence, we submit a degree of our decision-making to the
crowd, or at least the crowd that we belong to. This does not mean the
crowd is always right of course, but that is not the point, the point is
that we are heavily influenced by the crowd. As if to emphasise this,
just take a look at the performance of Hedge Funds in recent years: They
are considered the 'Alphas' of the investment world, yet since 2011 the
US stock market is up around 70%, whilst US equity funds as a group are
down close to 10%. Equity Hedge Funds have been herding around a
bearish view for some time, Barry Ritholz discusses this in his recent
article 'When “Fringe” Sentiment Dominates Psychology'.
Jon Maynard Keynes first identified this when he compared the way
investors pick stocks to how one could develop an approach for picking
winners of a newspaper beauty contest (of the type common in the 1930s).
In these contests, pictures of women would be displayed in a newspaper.
The most popular selection picked by readers would be declared the
winner. A prize would go to one reader, selected at random, from those
who voted for the most popular choice.
"It is not a case of choosing those [faces] that, to the best of one's
judgment, are really the prettiest, nor even those that average opinion
genuinely thinks the prettiest. We have reached the third degree where
we devote our intelligences to anticipating what average opinion expects
the average opinion to be. And there are some, I believe, who practice
the fourth, fifth and higher degrees."
(Keynes, General Theory of
Employment, Interest and Money, 1936).
This can help us understand why markets trend rather than just jump to a new level of value. Personally I can not think of a better reason to buy a
stock than the belief that everyone else will be buying it. - On the other hand, when we are long of something and it is moving the other way, our negative emotional response is not just because we are wrong, it is also because we are feeling a little uncomfortable being against the crowd. The emotional response we are having at that point is not a choice we make, it is chosen for us by our ancient nervous system. - This happened because as a species we are social beings: Our ancestors learned to cooperate, share and be
mutually dependent on each other, this greatly
increased their chances of survival. Those ‘conforming individuals’ were the ones who came to pass on their DNA. Those who did not conform were more
likely to be rejected by social groups. These 'rejects' would have to fend for
themselves in the harsh natural environments our ancestors inhabited, which could mean almost certain death. If you ever wondered where our innate 'fear of rejection' stems from, there is your answer. - For 'Fear of Rejection' also see 'Fear of Missing Out' or FOMO.
What about contrarians?
Fortunately as humans we are not completely hostage to our emotions, we do have the ability to 'learn' to temper our feelings, which allows us to modify our behaviours. Contrarians have become particularly adept at this. They are able to spot patterns where the crowd inevitably reaches an extreme. In trading, there is always an
extreme for momentum, a point where the trade is crowded. At this point, if enough people exit together, the momentum
turns the other way, sometimes with great rapidity. - Being a contrarian is an
art, I know people who are always contrarian, they wait until they
think the market is overextended then fight it. Many successful traders
have made a career out of being contrarians, sometimes dicing dangerously with 'capital/liquidity death' along the way.
Good momentum traders on the hand prefer to go with the crowd. They are able to run with the momentum, and exit in a timely manner just as the contrarians are sharpening their claws. Good contrarians are excellent at picking extremes in the momentum, but bad contrarians actually help the trend, selling into a rising market not ready to turn, but then being forced to buy back at a higher level.
Alpha R Cubed delivers cutting edge 'Behavioural Performance Coaching Programmes' which help traders and investment professionals learn more about their own 'Behavioural Biases'. Our powerful programmes facilitate people to transform their behaviours, leading to significantly enhanced performance and far stronger returns. If you would like to know more about our programmes, please click on the image below, or email me steven.goldstein@alpharcubed.com or at info@alpharcubed.com. Visit us at www.alpharcubed.com to learn more.
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