Behavioral Mistakes In Trading
Last Updated on May 8, 2023
No matter how good strategies you have, they are most likely worthless if you can’t execute them properly due to behavioral mistakes in trading. What looks like a piece of cake in a backtest, is completely different in the real world when you are risking your own hard-earned money.
To avoid behavioral mistakes in trading is more important than the strategy. If you can’t minimize behavioral mistakes, you will deviate from what the strategy tells you to do.
This article contains two examples of behavioral mistakes and how they influence profits. One is taken from a book and one is from my own trading career.
Will the strategy continue to perform after a drawdown? Is it just a temporary setback?
The future is always uncertain and it’s pretty common to give up a good strategy after a setback or drawdown. How likely is it that you are going to do what the strategy tells you to do?
Behavioral mistakes are an important “cost” to consider in both investing and short-term trading. We all fall prey to our cognitive biases, be it in relationships, decision making, or in your daily job.
The Art Of Thinking Clearly
We all fall prey to cognitive errors and behavioral mistakes. When money is at stake these tendencies magnify, and we tend to do more of them. What exactly are cognitive errors (or behavioral mistakes)? I copy the definition by the Swiss author Rolf Dobelli in The Art of Thinking Clearly:
The failure to think clearly, or what experts call a “cognitive error”, is a systematic deviation from logic – from optimal, rational, reasonable thought and behaviour. By “systematic” I mean that these are not just occasional errors in judgement, but rather routine mistakes, barriers to logic we stumble over time and again, repeating patterns through generations and through the centuries. For example, it is much more common that we overestimate our knowledge than that we underestimate it. Similarly, the danger of losing something stimulates us much more than the prospect of making a similar gain. In the presence of other people we tend to adjust our behaviour to theirs, not the opposite. Anecdotes make us overlook the statistical distribution (base rate) behind it, not the other way around.
The book by Dobelli reads well and summarizes much of the research by Kahneman and Tversky into a shorter and more enjoyable read.
What are some of the major behavioral trading biases?
The list of trading biases is almost endless. We have previously written about some of the most obvious in addition to the two mentioned below in this article.
Decision making is part of our daily lives and I consider reading a cheap investment for learning and understanding more about yourself:
If you know yourself, you understand the markets
If you know yourself very well, I would say you should better understand markets and thus make more money trading or investing. Mark Douglas writes in Disciplined Trader (page 56):
“Understanding yourself is synonymous with understanding the markets because as a trader you are part of the collective force that moves prices. How could you begin to understand the dynamics of group behaviour well enough to extract money from the group, as a result of their behaviour, if you don’t understand the inner forces that affect your own?”
How to lose money in the best performing fund
Below is a pretty interesting excerpt that has been circulating in social media for some years (I found it in Quantitative Value by Wesley Gray and Tobias Carlisle). In the decade ending in 2010, the majority of the investors in the best performing fund managed to lose money!
In the decade to December 31, 2009, the Wall Street Journal reported that the best-performed U.S. diversified stock mutual fund according to fund-tracker Morningstar was Ken Heebner’s CGM Focus Fund. Over the decade, the fund had gained 18.2 percent annually, beating its closest rival by 3.4 percent per year, which is exceptional. The typical investor in Heebner’s fund, however, lost 11 percent annually. Investor returns, also known as “dollar-weighted returns,” take into account the capital flowing into and out of the fund as investors buy and sell. The investor returns were lower than the fund’s total returns because investors bought into the fund after it had a strong run and then sold as it hit bottom. Heebner’s fund surged 80 percent in 2007, and then investors poured in $2.6 billion. The following year, the fund sunk 48 percent, and investors yanked out more than $750 million. Said Heebner: “A huge amount of money came in right when the performance of the fund was at a peak. I don’t know what to say about that. We don’t have any control over what investors do.” This behavior caused the investor returns in Heebner’s fund to be among the worst of any fund tracked by Morningstar. Amazingly, this means that the worst investor returns were found in the decade’s best-performed fund. We are each our own worst enemy.”
My own big behavioral trading mistake
I can’t remember my best trades as there is not much to learn from them. I rather focus on trying to avoid ruin and huge mistakes. To illustrate how difficult trading is, I want to finish this short article by writing about my biggest mistake during my day trading career:
I clearly remember two days in August 2007 where I completely screwed up. It was a Thursday and all my day trading strategies performed badly, ending my day with my biggest financial loss ever. I probably react twice as bad to a loss as a react positively on an equal gain, like most people, and thus this loss made me feel pretty bad. I have loss aversion.
The next day was the third Friday of the month where options expire. Historically this has been the best day of the month (for my strategies) but I was so shaken by the loss the day before so I scaled down all my strategies as much as I could. Needless to say, Friday was a field day and would have generated 2x times the loss from the day before if I had traded my normal size (I managed to recoup just 20% of my losses).
Even with very good strategies, it’s possible to end up losing because of wrong position sizing behavioral mistakes!
Oddmund, probably you did everything correct, changing position size after hitting maximum drawdown in one day. I would cut to 20% position size if previous day drawdown hit x5 maximum drawdown. It’s normal adaptive trading behavior. Thanks for sharing your experience.
Perhaps, but then you are not trading the strategy according to the plan, unless you have adjusted for this in any backtest. This is why backtests are so misleading, because they don’t take into account such “disasters”.
This is the reason i set margin of safety for maximum drawdown to exceed x3 then give some time for systems to cool down, and re-calculate position size or review/disable system after some time… Also it is a good idea to have multi non-correlated assets/alphas in portfolio to reduce impact of individual outliers. Oddmund, do you trade Australian stock market?
I don’t trade Australian stocks/market. You do? I have never looked into it. I do agree you should seek uncorrelated markets, but in crisis they more or less all move together. Tail-risk and outliers are impossible to hedge against as far as i can see, it’s a bleeding process.
Currently I trade very small and focus mostly on long-term investing.
Hey, Oddmund. I am also new to Australian stocks, going to try them. Australian stock market is rather young, only 33 years, founded in 1st april of 1987.
I agree about sometimes crisis hit very hard and many assets/systems become more correlated. In this case you have to remember that cash is also position. Also volatility & short systems dominate at times of crisis.
Long-term investing, do you use market timing to avoid crisis time in investing?
For long-term investing I don’t use market timing at all. I just buy a stock I believe will earns a lot more 1-2 decades ahead in the future, and that’s all.
In trading,however, I use market timing all the time 🙂