Killer Biases: How 'Cognitive Dissonance' Devastates Trading & Investment Performance.

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 scientific principles. 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 and take 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 no novice 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)'. 

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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.

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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’.
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Beyond the Hype: The 10 Behavioural Traits of Highly Successful Traders.

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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.

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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.

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The Pre-Mortem: A De-Biasing Technique to Increase Trading and Investment Success.

Imagine you had the rare ability to be able to see into the future. How wonderful would it be to be able to know what was going to happen, to make accurate forecasts, to produce prophetical spot-on predictions. A nice thought but sadly one that, in the absence of magical or divine powers, is no more than a pipe-dream. Perhaps the next best thing would be 'Forward hindsight' the ability to say, 'I knew that was going to happen' and to have acted upon that. However, perhaps there is a way to have that rare gift to develop forward hindsight after all!

Extensive research has found that ‘prospective hindsight’ imagining that an event has already occurred—increases the ability to correctly identify reasons for future outcomes by 30%. In my coaching work I encourage people to consider employing a technique called the 'Pre-Mortem'. This technique, invented by the psychologist Gary Klein, is a tool or process which Daniel Kahneman, his Nobel-winning colleague, describes as his favourite method for making better decisions. When doing a 'Pre-Mortem', you imagine yourself in the future, after a project which has failed 'spectacularly'. You then explore the potential reasons for that future failure. 

Whilst this tool was conceived for projects, as a technique I find it can make a huge difference to people's trading and investment performance.

Prospective Hindsight: Helping Overcome the Uncertainty Challenge in Financial Markets.

One of the key rationales for using the ‘Pre-Mortem’ in Financial Market settings, is to bring understanding to complexity, and to limit the negative and unsettling impacts of 'uncertainty'. The following graphic highlights four different type of environments which people find themselves in when faced with challenges.

This model is a simplified adaption of the ‘Cynafin’ model. The top left hand corner describes the environment typically found in financial markets, The 'Complex environment'. The 'Complex environment' is the domain of sensory information, this type of environment is one of heightened uncertainty, rapidly changing condition, and limited information.

Problem solving in this 'Complex environment' requires a particular type of response. However often we engage in problem solving more suited to a 'Complicated environment'. This is section toward the 'top right' corner of the graphic. The complicated environment, is the domain where expertise is required, however it is a fairly static environment, thus as long as the problem is understood by the expert, then they can resolve it. In our society we have been largely conditioned through education and training for  the ‘complicated’ environment, the ‘top right’ hand corner of this graphic. 

Problem solving in the 'Complicated Environment'. 

 

However, this process falls short when practiced in a ‘Complex environment’, with its heightened level of uncertainty and only partial information. In this environment, the process for dealing with problems and challenges is best described as:

It is with this highly uncertain environment of constant re-calibration, changing situations, new news, ongoing events, that people’s ability to respond effectively is highly challenged, and that their biases and human limitations come to the fore.

Pre-Mortem thinking in a ‘trading and investment’ environment.

A pre-mortem process is usually carried out by a team working on a project. All project team members are asked to write down every reason they can think of for the failure. These reasons for failure are then discussed openly.

Although project teams will have engaged in risk analysis, the pre-mortem’s ‘prospective hindsight’ approach offers benefits that other methods don’t. It focuses attention on whether assumptions may be incorrect and raises exploration on concerns which were originally dismissed. This counters some of the thinking which causes people to become over-invested in a project or idea. Additionally, the exercise sensitizes the team to pick up early signs of trouble once the project gets under way. Use of the ‘Pre-Mortem’, has led to spectacular improvements in project success.

Applying the Pre-Mortem to Trading and Investment.

Although Pre-Mortems are a team process used predominantly in projects, one can adopt ‘Pre-Mortem’ thinking to trading and investment settings, both in teams and group, as well as individually. Consider the team meetings which typically occur in an investment bank or hedge fund. How often is an idea or view railroaded through a meeting, often by the loudest voice, most senior individuals, or by a pre-agreed consensus? How often does this come to affect thinking and drive subsequent behaviours and actions? Adopting a ‘Pre-Mortem’ approach to these team meetings could help produce a more thorough robust process which de-biases proceedings, improves the success rate of these meetings and the ideas generated, and enhances the subsequent execution of these ideas.

Additionally, applied to individual trading and investment behaviours and analysis processes, ‘pre-mortem’ thinking can help improve traders and portfolio-managers’ success rate, and help sales-people improve their service to clients and customers. As a coach, I encourage people to try and adopt pre-mortem thinking within aspects of their work, from how they analyse markets, to how they execute their actions, to how they manage their risks and capital.

Countering Behavioural Biases and Limitations.

This is one of my favourite illusions. I often lead with this one on 'Behavioural Finance' seminars and workshops I give. No matter how much I try and tell people that square A and square B are identical colours, no one believes it. And the truth is, that even though I know they are the same colour, they still look different to me. Our brains don't work the way we think they do! - To see this illusion proved and exlained go to http://web.mit.edu/persci/people/adelson/checkershadow_proof.html

Behavioural finance research over the past two decades has provided deep insight into how human behavioural limitations impact people’s abilities to behave and act rationally within trading and investment activities. Behavioural finance experts and economists tend to think of these as flaws in people’s thinking, the ‘Naturalist Decision Making’ school of thought however views these biases and limitations as part of how we operate, rather than necessarily being flaws. Accepting that this is how we ‘work’ allows us to then come up with ways to work better. ‘Pre-Mortem’ thinking is one way to help achieve this’.

The following 2 examples are from clients of mine who have successfully integrated 'Pre-mortem thinking into their working practices, with very powerful results. 

Client A was a Hedge Fund options trader. – He used a quantitative and systematic approach, creating elaborate models, and thoroughly back-testing ideas. His whole process appeared highly automated, yet at the core there was a significant discretionary element. In reviewing his process and trades and looking at examples over many years, a pattern which was becoming clear. He would start to fall ‘in love’ with certain ideas or views to the extent to that this would start to obscure objectivity. Once this happened all subsequent activities were impacted, the trader’s ‘Confirmation Bias’ ensured that he was now always seeking to prove this view and then designing an idea and concept around this. By encouraging the trader to bring ‘Pre-Mortem’ thinking into his working approach, he started to counter this bias. – He would run a ‘Pre-Mortem’ ahead of all stages of his process. He would take the assumption that the idea had failed and left him with a large loss or sub-par outcome. – He then ran a quick check of all possible reasons. – He had constructed a checklist, which he had evolved and was continuing to evolve. – Amongst checklist points was the idea that he had failed because he had over-committed to an idea, and had not tried to ‘disprove this idea’ sufficiently. This process, then led to various subsequent actions; where this process did not destroy the idea, he  actually had a more real and genuine confidence in the idea. – The upshot was a big improvement in trading performance over time. –

This above example applied to an options trader who used a systematic quantitative approach. It may not seem like it is applicable to the rough and tumble, and rapid decision making of the short-term FX trading world, but this could not be further from the truth.

Client B was a short-term trader on the FX desk at a bank. Amongst his issues, ‘Fear of Failure’ and ‘Fear of Missing Out’, were obscuring clarity around his trading and led to an erratic execution process. Though still making money, his performance was adequate rather than outstanding. He felt that the short-term trading requirement of his work limited his room for manoeuvre when it came to planning, and thus at first felt that the pre-mortem approach was not appropriate for him. – Nonetheless he subsequently agreed to try it to help his position management practices, rather than trade execution. – Every evening and every morning he conducted a 5 minute ‘Pre-Mortem’. – The question he asked of himself was:

‘In the subsequent 12 hours his position had been stopped out for a significant loss’, or ‘had moved in the right direction, but he had failed to maintain his positions and thus missed out on a significant profit’ – what caused this?

Using ‘Prospective Hindsight’ he started to become more conscious of what was leading to sub-par decisions over his position management, and started to become more ‘forward-thinking’ in terms of his position management. This lead to significant improvements in p/l. This ‘pre-mortem’ mindset approach has now become a broader part of his approach, even with in his short-term reactionary trading. This has led to  a stunning performance improvement, more than doubling his best ever year in each of the past two years. This trader is one of the ROI examples featured in this article. 

Pre-Mortem as part of developing the 'Behavioural Edge'. 

A 'Behavioural Edge' is the most powerful edge one can have in trading and investment. It is what separates the superstars of trading from the rest of the field. Our article 'The 10 Behavioural Traits of Highly Successful Traders & Investment Professionals', explores the traits displayed by highly successful traders and portfolio managers which contribute to deeloping a behavioural edge. These traits are remarkably consistent across most of these traders. Amongst these Trait 6) 'Planning, Preparation, Patience and Discipline', and Trait 9) 'Focus on making money, not being right' are both directly supported by the 'Pre-mortem' approach. The pre-mortem approach is a key part of helping to develop one's 'Behavioural edge'. 

Summary

The pre-mortem approach is very different to ‘brainstorming, and ‘risk-analysis’. It is a de-biasing technique, which brings greater robustness and soundness to analysis, risk and money manegement, portfolio management, and idea implementation. I have used the process to help teams and businesses within trading and investment settings with some outstanding outcomes. I encourage individuals, whether they are leaders, risk-takers or salespeople, to bring this approach into their habitual way of being in their work, it can and does make a huge difference. The great South African golfer Gary Player said, ‘Luck is what happens when preparation meets opportunity’, the pre-mortem ensures that when luck meets opportunity, the trader is better prepared for it. 

If you have enjoyed reading this article, and would like to know more about our 'Behavioural Performance Coaching' work with Traders and Investment Professionals. Please feel free to email me: steven.goldstein@alpharcubed.com. Alternatively visit the website www.alpharcubed.com.
 
You can also join the flourishing LinkedIn Group ' Behavioural Trading'. and follow me on Twitter.