Last Updated on March 19, 2021 by Oddmund Groette
Mankind has come a long way in problem solving and technical advancements, but most of us still suck when it comes to financial planning and managing our investments. We have created artificial intelligence and we send people to outer space, yet most of us are hopeless when it comes to trading and investments. A lot of research determines that the average DIY investor underperforms the indices by a wide margin.
The main obstacle to success is our mental behavioral biases. Why is that? Scientists point to evolution: our brains are designed to keep us safe from risk and dangers to survive, and this is a different matter than what is required in the financial markets.
Don’t get me wrong, you first need to survive in the financial marketplace before making any money. But to survive on the savanna and in the markets requires different skillsets. On the savanna, you can’t sit down to evaluate the pros and cons when you face danger – you use your intuition to get away as fast as possible. In the markets, it pays off to do a little thinking, the so-called System 2:
Daniel Kahneman’s System 1 and System 2 explained:
Daniel Kahneman, a pioneer in behavioral studies, calls the two different types of thinking for System 1 and System 2. System 1 is fast and intuitive while System 2 is the slow and analytical one. This is how Kahneman defines his two systems in his bestselling book Thinking, Fast And Slow:
System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control. System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.
The marketplace is complex and full of noise and randomness and thus ut rarely helps to make knee-jerk decisions. Our investing instincts are mostly flawed, unfortunately.
What is a behavioral bias?
The famous financial writer Morgan Housel once said that investing is not the study of finance, it’s the study of how people behave with money. Housel’s definition explains why we often get it so wrong when money is at stake.
A bias is a behavioral mistake – a cognitive error. In The Art Of Thinking Clearly, Rolf Dobelli defines cognitive errors as systematic deviations from logic and rational behavior. Dobelli uses the word “systematic” because these are not occasional mistakes we make, but barriers to logic we stumble upon over and over again. This is not something that has happened recently, but it’s ingrained mistakes done through generations and centuries.
Here are two examples of biases: we are much more likely to overestimate our knowledge than we are to underestimate it. Likewise, we repeatedly make statistical errors that overlook the most basic statistical distributions to jump to the wrong conclusions.
Example: optimism/pessimism bias
The optimism/pessimism bias is a common one among traders. After a good run, you feel great and optimistic and increase the size. Opposite, after a bad run of “luck”, you feel pessimistic and reduce your size. However, good and bad runs happen all the time in trading. I have myself been prone to this bias many times. Here’s an example from my own trading:
Back in 2007, I had a very nice run over the summer where my trading performed very well. I felt good, I was very optimistic, and increased the size to make more money. I was greedy.
Then, out of the blue, some Black Swan event happened, which my backtest never captured. I suffered my biggest loss where two months’ of profits were wiped out in two minutes. Out of fear, the next day I reduced my position size as much as I could. Unfortunately, the next day was a triple-witching day where all options and futures contracts expire. Historically, these days have frequently been “monster” days contributing to a huge portion of my profits. Perhaps needless to say, the day turned out to be one of those monster days. If I had traded my normal size, I would have made 3x the loss the day before and had my best trading day ever.
Likewise, one of the best mutual funds from 2000 until 2010, Ken Heebner’s CGM Focus fund, gained 18.2% annually while the typical investor lost 11% annually. How is this possible? That’s because the “dollar-weighted returns” take into account the capital inflows and outflows. Investors typically bought into the fund after it had a strong run and then sold as it went down. In 2007 the fund surged 80% and it attracted huge amounts of inflows, while many of those sold during the GFC in 2008/09. Hebner said:
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.
The conclusion is simple: It doesn’t matter how good your trading systems are if you can’t execute and trade them properly. The main obstacle for traders is their own mental biases.
We have given a list of the most common behavioral mistakes in a previous article:
How to overcome biases:
To diagnose the problem we first need to understand why we have biases. In medicine, you can take pills to relieve pain, but the pills only treat the symptoms – not the cause. In trading, you don’t have a pain killer. You have to go to the root of the problem and look at the cause (which should be more used in health and medicine as well). Once you understand how your behavior influences your trading, you can overcome or minimize them to increase your profits.
Is it possible to completely remove behavioral mistakes? Probably not. But you get a long way by addressing the issues so you can minimize the damage done by knee-jerk decisions.
No detachment to money reduces behavioral biases
Almost all the behavioral mistakes come from detachment to money. Anyone can be successful trading a paper account. But the problem is that a paper or demo account never resembles real trading with real money. You have no skin in the game. To make it worse, most traders use leverage and this magnifies your detachment to money. With real money you are more likely to tweak or stop trading a strategy in the midst of drawdown, something you wouldn’t do in a demo account.
Trade smaller than you like
How do you execute a strategy properly? You do that by trading small. This is not contradictory. By trading small, you remove emotions. Trading small is an efficient way of reducing detachment to money! Moreover, by trading small you reduce the risk of ruin. If you trade big using leverage and get run over by a black swan, you might lose a huge portion of your account.
Trade small and make your are diversified in terms of asset classes, strategies, and time frames.
Quantified strategies – algorithmic trading
Most likely, you will never overcome your biases completely, but just knowing them is a great start. Thus, the goal should be to minimize biases and make your trading as rational as you possibly can.
How do you do that? We believe quantitative trading offers the best way to minimize behavioral mistakes. Quantitative trading reduces your biases and errors because the computer creates a “layer” between you and your trading. The computer doesn’t think and is not susceptible to emotions – a computer only does what it’s told.
Using a checklist minimizes unforced errors
Morningstar once had a checklist for minimizing cognitive errors. We can’t find the link now, but I’m an eager students of the markets and wrote them down:
- Write down your biases on a piece of paper. This makes you aware of them.
- Turn down the noise. Be careful of getting overloaded by social media or the mainstream media.
- Force yourself to make slow decisions. Morningstar called them speed dumps for decisions.
- Look for confronting arguments. Be your own devil’s advocate.
- What is your margin of safety? What can go wrong?
- Thoughtfulness matters.
One of our favorite books is Atul Gawande’s The Checklist Manifesto. A checklist makes you avoid unforced errors, improves your outcome without any increase in skills, and saves you time in the investment process.
- What investors can learn from Atul Gawande’s The Checklist Manifesto
- Why you need an investment checklist
- Why it’s important to avoid investment mistakes (unforced errors)
Recommended reading to learn about biases:
There exists a ton of literature on most of the biases mentioned in this article. If you want an easy read we recommend Rolf Dobelli’s The Art Of Thinking Clearly. Still, the pioneer in the field of behavioral studies is Daniel Kahneman. His book from 2011, Thinking , Fast And Slow, is brilliant, but a bit more “academic” than Dobelli’s.