Optimism Bias: It can seriously affect your judgment and trading performance.

Optimism Bias: Is a natural human bias that causes a person to believe that they are less at risk of experiencing a negative event compared to others, or that they are more likely to succeed or be good at something than reality would suggest.

Firstly let me stress, ‘Optimism is good’, most successful traders I work with, as a coach, are typically optimistic, they believe they can beat the market and often do. However they are also self-aware and have a high degree of humbleness (Which tends to run contra to the popular image presented in modern day culture). As an ex-professional trader, I actually think we need a degree of optimism to switch on the screens and start trading every day. We need optimism to return to the fray after the market has given us a severe beating, and we need optimism to balance the natural fears we have which can cause us to panic out of certain trades or which lead to other poor decisions.

However, over-optimism, as emphasized by the optimism bias, can be extremely damaging: It forces people to take trades the should they never should engage in, warping their view of reality, and damaging their objectivity. All of which culminates in a state of ‘unrealistic optimism’! This matters, it matters a lot! As a consequence, people’s decision-making and judgment become heavily impaired, causing them to over-estimate the possibility of favourable outcomes, and under-estimate the likelihood that trades will fail. Ultimately their risk-reward is going to be skewed, perhaps quite heavily. Whether you are an investor or trader, and whether your approach is fundamentalist, technical or quant, whichever method is your poison, you need to have an edge, and that edge is the mathematical outcome of your risk/reward ratio.

This excellent and entertaining TED talk by Tali Sharot talks about the ‘Optimism Bias’ will illuminate you further on the ‘Over-optimism’ bias. 

What can you do to help you over-come the effects of ‘Optimism Bias’ in your trading? Firstly, I would say that you are unlikely to alter your actual ‘optimism bias’, it may vary in certain people and situations, but all people have it. Rather like your shadow, it will always be there, it is a part of you that evolution has welded into your psyche, and that acts in way to impact your perceptions and decisions just below the level of consciousness.

Nonetheless, there are certain ways you can behave or act to try and counter its effects.

1) Raising Awareness is a first step. Hopefully articles such as these are part of raising your awareness of ‘Optimism Bias’, though no doubt within a few days, if not hours of reading this, your memory and conscious awareness of ‘Optimism Bias’ is likely to fade. However a seed will hopefully have been planted that can be nourished through further reading of the human behavioural aspects of decision-making and other memory-stirring practices.

2) Creating a more structured way of trade selection, trade management, and risk-management should help combat optimism-bias. A more structured approach does not have to be too rigid and heavily rule based, by doing so I believe can harm your adaptability and creativity. However by developing certain rules or guidelines and trying to adhere to them, you should create a stronger discipline and allow yourself to create more control over the sub-conscious forces which can derail your trading.

3) Use a Trade Journal or Diary (Either written or electronic). This has many benefits, including:

• ­Supporting a more structured approach as discussed above.
• ­Allowing one to plan their trades more effectively, therefore creating greater objectivity.
• ­Reminding the person of the initial reason and rationale for the trade, and therefore helping to remain on track.
• ­But in this context, I like a trade journal as a ‘Behavioural Awareness’ tool: Let me explain: If you record many of your trading decisions you can then periodically look-back and review your decisions and actions. We rarely learn from our mistakes, because we tend to shut our minds to them. This is part of ‘Optimism Bias’, we don’t want to recall our stupidity or poor-trading as it damages our self-belief, therefore we often banish them from our memory thus allowing us to foster the ‘self-belief’ which is necessary for trading success. Unfortunately, the downside of this is that it also feeds one’s ‘Optimism Bias’. However, by recording reasons for our decisions, and the actions that followed, even just with a few words, (I prefer keeping journals simple: ‘Less is More’), then we can return to them in the future. By reviewing our journals through time, we can raise our awareness of our actions. I use to do this during my trading days and shocked myself when I realised some of the behavioural patterns and mistakes I was repeating. ‘If we are not aware of them, we can’t even start to address them’.

4) There are many other actions we can take to fight the ‘Optimism Bias’, such as seeking alternative opinions, looking at trades from alternative perspectives, active use of Stops/Trailing Stops etc. This is all part of the toolbox one develops during their trading experiences.

On the other hand, you have to ensure that you don’t extinguish your self-belief, it is important to remain optimistic in the face of the many challenges and hurdles that trading throws up. But one should always strive for greater realism and objectivity whilst trying to balance all these various divergent and opposing forces and finding a way which provides a clear edge to one’s trading.

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The 'Behavioural Trading' blog is written and managed by leading Trading Performance and Behavioural Trading Coach Steven Goldstein. Steven is Managing Director at Alpha R Cubed, who work with banks, hedge funds and investment firms to help them improve their people's capabilities within their frontline financial risk businesses. To know more about Alpha R Cubed, visit the website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven directly on Twitter.

MarketPsych - Social media, Behavioural Finance, Psychology and Neuroscience.

I came across a very interesting piece on a blog called ‘MarketPsych: Applying Behavior Finance’. I was particularly interested in their posting on the 3rd January this year. – The link is here. The title of the piece is ‘Using Reason+Emotion to Forecast 2012’.  The article grabbed my attention making some thought-provoking points and assertions and is well worth a read.

A couple of things jumped out at me, particularly in light of the fact that this article was posted on the 3rd January and how market events have unfolded since that time.

Firstly, their assertion that, ‘uncertainty is predictive - in a counter-intuitive way’. Looking at the way markets have started this year, this would go along way to answering all those people, and there are many, sitting around scratching their heads at the performance of the markets so far this year.

Secondly, and I find this really interesting, they have analysed and aggregated the past 13 years of social media chatter by year for 8,000 publicly traded U.S. companies. They found that December, perhaps not surprisingly, has been the happiest and most optimistic time of the year for investors. Perhaps this is one theory why markets tend to experience the ‘January effect’: The January effect has been known for many years and was first described some 70 years ago. Since 1991, not including this year, January has on average returned 6.7% on the SP500.

Following on from this analysis, they have conducted, in their own words -‘basic analysis’ - from which they have created forecasts for stock out- and under- performance using both emotion and reason as the inputs. As a result they identified five companies that they think may outperform and five who may underperform the market for 2012.

Given that this was published on their blog on the first Monday of January, I thought it would be interesting to see how these have fared so far this year. The following table shows % performance ‘Year to Date (YTD)’ as at the close of business on Friday (3 Feb 2012) for the suggested outperformers and underperformers. At the bottom of each group I have calculated the average performance for each group; I have also included the median performance, which I think gives a better reflection, due to the distorting effect of one outlier in a small group. It certainly looks very impressive thus far: 

Finally they talk about some interesting insights from neuroscience, which can have far reaching consequences for our own performance when trading and investing. Whilst it should be no surprise that people get excited when they do (and possibly believe they will) make money, it is however what is happening inside our brains that is fascinating. When we make money this triggers activation in the brain's reward system; however at the same time that excitement leads to a de-activation in the "loss avoidance" areas of the brain.  Let me just re-phrase that slightly: ‘When we become excited about making, or the prospect of making money, we become less able to detect risk, thus perhaps when we need it most, we let our guard down’. – Who as a trader or investor can not resonate with that? 

 

They also talk about how we become ‘emotionally primed’ when watching financial news, (and I would suggest when watching market price action, data releases, and other aspects of trading and investing). They assert that it is common for - our unconscious emotional state to shift from news story to news story - across a spectrum from joy to anger to fear - depending on the message of each story.  As these shifts occur, the brain shifts its decision-making from primarily neo-cortex (analytical) to primarily limbic (emotional).  And most importantly, this shift to emotional decision making is unconscious.

After such a shift, our rational brain (neo-cortex) believes that it is responding to financial circumstances and information as before, but in actuality it has been "emotionally primed" and is reacting to events from within an emotional frame.  

We see this in our own behaviours, when we hear frightening news; we react with more caution, whereas after favourable news, we are inclined to take on more risk. This ties in an aspect of my own ‘Trader Performance’ coaching, where  I suggest to clients that their major market analysis and indeed their thinking should where possible be done, in what I consider a ‘cold-state’, preferably not in front of screens, or away from market activity, or during quiet times. This way decisions and analysis are far more likely to be based in reason, whereas decisions taken in the heat of trading, ‘hot-state’ are far more likely to be poor decisions, based on emotional responses. (Please note; I like emotion as an input into decision making, so I do not suggest ignoring it, but the decisions themselves should be made in a rationale state of mind - where possible).

How money affects the way we behave and the psychotic tendencies of bankers.

Earlier this week ‘Zero Hedge’ published a piece titled 'Psychopaths caused the Financial Crisis and they will do it again’.

http://www.zerohedge.com/contributed/psychopaths-caused-financial-crisis-%E2%80%A6-and-they-will-do-it-again-and-again-unless-they-ar

Whether you agree with it or not, the sentiments may well hold true to a degree.

However I would like to tie this to another article form a few years earlier titled
‘Does Money Make You Mean’ which describes the findings of Psychologist Kathleen Vohs and colleagues.

http://www.bankrate.com/brm/news/pf/20070123_money_psychology_a1.asp

Of course it is a long stretch from money affecting the way we behave to becoming a financial psychopath, however I do find the link between the two curious and interesting.

Following on from this, and what may seem like a tenuous link, is this article by the wonderful Biju Dominic from March 2009 'Brains and Economic Crises'.

http://www.livemint.com/2009/03/09213450/Brains-and-economic-crises.html 

Procrastination: A bad habit which affects many traders.

In my coaching work with traders, there have been many cases where I have found occurrences of procrastination.  Procrastination takes on many forms, the classic definition is ‘putting off to tomorrow what we can do today’, however I tend to see it the way Piers Steel, author of ‘The Procrastination Equation’, describes it; ‘one procrastinates when one delays beginning’. – In a trading sense this manifests itself in many ways; failure to plan, failure to stick to a plan, perfectionism – waiting for the perfect set-up and hence not acting, hesitancy in pulling the trigger, choosing the safer option by continuing to analyse and watch the market rather than place the trade, which often leads to the cry –‘I knew that was going to happen’, or something along those lines. – One of my favourite quotes on trading is by Warren Buffett: – ‘Predicting rain doesn’t count, buildings arks does’.

Procrastination is a deeply entrenched habit.

The problem for many is that procrastination is a deeply ingrained habit; it is something we have learned to do throughout our life. – I have often harped on about ‘the 10,000 hour rule’, and how practice makes perfect, well during our lives it is quite possible we have spent many thousands of hours practicing at procrastinating, as such this has formed into a well entrenched and fully automated habit. Fortunately there is help at hand, and that helps involves developing new habits, habits which override and usurp that bad habits which are part of procrastination. Unfortunately for many procrastinators, it takes time, commitment, planning, effort and application, and as we know that is one thing which many procrastinators are not good at.

I will reference a couple of articles which explain a little more about procrastination, some of the causes of procrastination, and steps we can take to start overcoming procrastination. Before I do however I want to introduce the following excerpt by Daniel Goleman, in ‘Leadership: The Power of Emotional Intelligence – Selected Writings’ where he talks about trying to from new habits as a way of usurping old habits.

‘Doing the wrong thing is a habit that you have become an Olympic level master at—your neural wiring has made it a default option, what you do automatically. The neural connectivity for that is strong. When you start to form the new, better habit you essentially are creating new circuitry that competes with your old habit in a kind of neural Darwinism. To make the new habit strong enough, you have to use the power of neuroplasticity—you have to do it over and over again.

If you persist in the better habit, that new circuitry will connect and become more and more powerful, until one day you’ll do the right thing in the right way without a second thought. That means the circuitry has become so connected and thick that this is the brain’s new default option. With that change in the brain, the better habit will become your automatic choice.’

Procrastinators will always be recovering procrastinators.

‘Old habits don’t die, they merely hibernate’: It only takes a stimulus from the old days to return for the dormant pattern to re-assert itself. This is why no one is ever considered cured of alcoholism; instead it is drummed into them by Alcoholics Anonymous that they will always be recovering alcoholics, this mindset helps keep them on guard against returning to the habit. This is something we all have to guard against when trying to form a new habit, hence it is useful to try and adopt a mindset that helps us to overcome these issues. Of course, procrastination does not have the same level of gravitas as ‘alcoholism’, and hence we are not likely to carry this around with us in our mindset to the same degree, also we cannot avoid the environment of work, like we can a pub or bar. However, we can take actions to try and keep it at the forefront of our minds; after all it is almost certainly serious enough to make a major dent in your earnings from trading, or even to be a cause of trading failure. I suggest placing small reminders around which are intended to jog our memory of the beneficial habit and thus avoiding returning to the destructive habit. Maintaining a journal, and placing reminders prominently in the journal are useful, also small physical reminders and inspirations are useful around your work place, and perhaps well located in your home.

Links to articles about procrastination and steps to overcome it.

The following link is to an article from the 'Psych Central’ website. It discusses some of the causes of Procrastination, included in these are Irrational beliefs, Perfectionism, Fear, and Disorganization, some or all of which are aspects which traders should be able to identify with.

http://psychcentral.com/library/procrastination.html

The second link attached is the follow-up to this, it includes how to tackle procrastination and how to take greater control of your ‘self’, which I believe should help lead to ‘better trading’. Amongst one of the steps recommended is keeping my old friend ‘the journal’, something which I strongly advocate to all traders.

http://psychcentral.com/library/procrastination.html

And finally, I shall finish with a humourous quote by Gloria Pitzer -

“Procrastination is my sin. It brings me naught but sorrow. I know that I should stop it. In fact, I will--tomorrow”