Trading Psychology: profit maximisation by understanding yourself and other market participants
Author: Tim Short
I am a former investment banking and securitisation specialist, having spent nearly a decade on the trading floor of several international investment banks. Throughout my career, I worked closely with syndicate/traders in order to establish the types of paper which would trade well and gained significant and broad experience in financial markets.
Many people have trading experience similar to the above. What marks me out is what I did next. I decided to pursue my interest in philosophy at Doctoral level, specialising in the psychology of how we predict and explain the behaviour of others, and in particular, the errors or biases we are prone to in that process. I have used my experience to write The Psychology of Successful Trading. In this book, I combine the above experience and knowledge to show how biases can lead to inaccurate predictions of the behaviour of other market participants, and how remedying those biases can lead to better predictions and major profits. Learn more on the About Me page.
Understandingbasic psychology is one of the most important but alsomost neglected tasks for investors.Of course, everyone realises that they need to analyse the investments they are considering buying.But many traders do not realise that winning in investment is also about successfully predicting what other market players will do.And that is a psychological task.
Most of the advice on the internet is not really psychology.It is quasi-psychology.You might get famous traders telling you things like “I always played tennis in the morning before my best trades to make sure I felt good.”This is useless.By all means, study what these guys do to get insights into how they analyse opportunities and maybe any tricks they have for bouncing back from a loss.But famous traders don’t have any specific training in psychology so if you are specifically wanting to improve your own trading psychology, adopting their tips (such as the tennis one above)won’t really help you in achieving that goal.
Alternatively, there are some actual psychologists who write on the topic and are experts in the field of psychology.But be careful about their specialisms.Someone who is a clinical psychologist may be an expertin schizophrenia but not necessarily other aspects of human psychology. And of course the main thing is that these expertsdo not have any serious trading experience, so they also can’t help you improve your trading psychology.
To identify the right sort of person, you need to ask two questions: does this person have significant trading experience and are they qualified in a related field?I am one of these people.
To try to convince you of this, I will outline my ideas on how to optimise your trading psychology.The first thing to know about is that we have a lot of cognitive biases —mental shortcuts that are often useful when we want a quick and dirty answer and often very unhelpful when we are trying to get something right.One example is Confirmation Bias, where people look only for evidence that supports what they already believe.There have been manyrobust psychology experiments published,that show time and time again that we do this often and consistently.
The first thing to note here is that if you use this bias when making your own trading decisions, you will make bad decisions.Every time!So you will definitely not be optimising your trading psychology.But here’s the key point: everyone else in the markets will be doing it too.
So what does that mean?It means you need to know about Confirmation Bias and think about it in a market context.Look out for it in yourself and be careful.Expect it in other market players and trade accordingly.
That’s how you stand the best chance of optimising your trading psychology.
Strumia made the claim of the title in a controversial talk at CERN.* I will show that this claim is falsified by the psychological literature.
There are a large number of cognitive biases operative in our psychology: over 180 at the last count, and that is just the ones we know about so far.All of these biases share the characteristics of being largely invisible to us in their operation and extremely hard to eradicate.Data show for example that significant financial incentives do not cause reduction of the effects of some of these biases.And I have discussed myself at length (Short, 2017) the way biases can cause highly suboptimal decision-making, even when there are very serious financial consequences.
The types of bias I mean would be exemplified by Confirmation Bias, which occurs when people look for evidence which confirms hypotheses they already believe.I think we should also consider Gender Bias in this same arena, though the claim we should not represents an objection to my position.I will show below that my position has adequate resources to defeat that objection, but first I will show that intelligence offers no protection against implicit biases.
I will do that by mentioning three types of bias where it was not the case that more intelligent subjects exhibited less bias, and then making a broader point.
Myside Bias — this is related to Confirmation Bias.It occurs when people evaluate and generate evidence or test hypotheses in a way that conforms to their prior opinions and attitudes.Stanovich, West and Toplak (2013, p. 259) found that the “magnitude of the myside bias shows very little relation to intelligence.”
Dunning-Kruger Effect — this is best known as the claim that unskilled persons also lack insight into their relatively poor abilities in an area.However, similar bias effects operate at the other end of the spectrum. Schlösser et al. (2013, p. 85) report that their model “partially explained why top performers underestimate their performances.”(I am assuming a correlation here between high intelligence and an ability to be a top performer in the fields of endeavour examined by the authors.)But here we see that intelligent subjects are also not immune from a variant of the Dunning-Kruger Effect.
The Gambler’s Fallacy — this is the tendency to think that fixed probabilities are altered by past events.For example, the odds of getting heads on throwing a fair coin are always 50%, irrespective of what has happened previously.If someone sees heads ten times in a row and then says either “it must be heads again next” or the opposite, they are exhibiting this apparently maladaptive heuristic.Xue et al. (2012) found that “individuals’ use of the [Gambler’s Fallacy] strategy was positively correlated with their general intelligence.’’
More generally, we may note that many experiments in social psychology are conducted on psychology undergraduates.This has been mooted in the past as a potential “ecological” objection, meaning that the results could be unrepresentative of the general population.Nevertheless, robust and widely replicated data exists to show the existence of 180+ cognitive biases.We may assume that undergraduates in psychology are a more intelligent subset than the population in general.
I will close by considering one potential objection to my account.This is that Gender Bias is not a cognitive bias and should not be considered in the group above where intelligence is not a protective factor.I will counter this objection in a number of ways.
If Gender Bias is not a cognitive bias, what is it?It results in a systematic slanting of judgements away from what would be strictly rational, and that accords precisely with my working definition of a bias (Short, 2015).
I do not need to assume a narrow and precise definition for Gender Bias.I am including within it all of what people refer to by the terms Sex Discrimination, Sexual Discrimination, Homophobia, Anti-LGBTQ+ prejudice etc.These discriminations often take place via stereotyping — assuming that everyone in group X has certain characteristics which may in fact be possessed by only some or indeed none of the members of group X.Stereotyping appears on the standard list of cognitive biases.
Krieger (1995) explicitly considers racial bias within a cognitive bias framework and includes also discussion of Gender Bias.
I conclude that this objection fails, and that therefore the claim that intelligence protects against implicit bias is false.
*According to a letter published by the Office of the Chair, Department of Physics and Astronomy, University of California, Irvine on 01 October 2018.
Krieger, L H1995. The Content of Our Categories: A Cognitive Bias Approach to Discrimination and Equal Employment Opportunity. Stanford Law Review47.6 pp. 1161–1248
Schlösser, T, Dunning, D Johnson K L, Kruger J2013How unaware are the unskilled? Empirical tests of the “signal extraction” counterexplanation for the Dunning–Kruger effect in self-evaluation of performanceJournal of Economic Psychology 39, December 2013, pp. 85–100, DOI: 10.1016/j.joep.2013.07.004
Short, T L2015Simulation Theory: A psychological and philosophical consideration, Psychology Press,ISBN 9781317598145
Short, T, L2017The Psychology of Successful Trading: Behavioural Strategies for Profitability, Routledge, ISBN 9781351601016
Stanovich, K E, West, R F and Toplak, M E2013Myside Bias, Rational Thinking, and Intelligence, Current Directions in Psychological Science, 22. 4, pp. 259–264, DOI: 10.1177/0963721413480174
Xue, G,He, Q, Lei, X, Chen, C,Liu, Y,Chen, C, Lu, Z-L, Dong, Q, Bechara, AThe Gambler’s Fallacy Is Associated with Weak Affective Decision Making but Strong Cognitive Ability PLOS One, October 5, 2012DOI: 10.1371/journal.pone.0047019
People often ask what the common stock market terminology of bullish or bearish means.While these have standard meanings in normal speech — bullish being positive or optimistic, and bearish being the opposite — at least the term “bear market” has a precise technical definition in the arena of stocks.I will explain this here.
The formal definition of a bear market is a market that has declined 20%.
The first item to clear up on the way to understanding the definition is “what do we mean by a market?”Normally people will be talking about a particular stock market index, such as for example the Dow Jones Industrial Average (“DJIA”), the S&P 500 or the Nikkei-225 (“N-225”).So now we want to know what a stock market index is.
Individual shares go up and down all the time.One cannot say what is happening in more broad terms to “the market” by looking at single shares because of this volatility.So instead, one looks at a basket of shares.That is what an index is: a basket of shares listed in a specific location.There are thousand of these, and they can be selected in many different ways.
To illustrate this, the DJIA is a basket of 30 major US shares that are selected so that they represent a good spread of major US stocks in different sectors such as computers, aircraft manufacture and banking.The S&P 500 is a broader basket of shares issued by the 500 largest public companies listed in the US.The N-225 is somewhat different as it is made up of the 225 largest stocks listed in Tokyo.It is price weighted, meaning that more expensive stocks will be more heavily influential in the movement of the index.
So, put simply, if all of the component stocks in the DJIA go down 20% in a period, the whole index will also go down 20% over that time.Since this index and the others are a broader measure of market sentiment than any single stock, if the DJIA goes down 20% in a period, we can say that it was a bearish episode for the market.Since that is an approximate measure of the health of blue chip US equities, one would also be justified in saying that that period was a bearish period more generally for major US companies.
The DJIA has been published since 1896.The graph looks like a long uptrend punctuated by occasional bear markets.You can see this below.
People tend to talk less about the technical definition of a bull market — they will often use it more colloquially to just mean “stocks are going up.”But if one wanted to be precise, it would just be the opposite of a bear market.It would mean that a particular index had increased by 20% from a trough.
I recently discussed (in Investment Styles) the two major different styles of investing: value and momentum. One difficulty with following a value approach is the difficulty in measuring value, since much of it these days is tied up in intangible assets. I will suggest here that, counter-intuitively, buying bank stocks is the solution to this problem.
The value approach to investing is simple to understand, though perhaps a little harder to implement. The basic idea is that you buy things when they are cheap. Finding cheap assets would classically rely on looking at concepts like “book value,” which is just the accounting value of everything owned by the firm in which you are thinking of investing.
In previous decades, book value would have been simple to calculate: you could just look at the published accounts and examine how much the accountants said each asset was worth. A company making cars, say, would own a lot of items like factories, car parts, machinery and land. You could look at all of those items that you could walk up to and touch, and add up all the values, and that’s it: you have calculated book value. If you can buy the stock for less than book value per stock, you have made a good investment. If the company sold all of its assets, and turned that book value into actual cash, each shareholder would get more than book value. That’s why value investing is a good idea, and why you should try to buy stocks at less than book value.
This simple approach is more difficult in modern times, because IP — Intellectual Property — is much more important than it used to be. IP is anything the company owns which is valuable but that you can’t touch. It could be a suite of software, the value of a brand, or
simply the know-how involved in producing the products or services that the company produces. To illustrate the scale of this IP problem for value investors, consider the following estimate. Ocean Tomo, an investment bank, reckoned that the proportion of the value of S&P500 companies which was tied up in IP increased from 17% in 1975 to a huge 84% in 2015. So it is clear that there is a very serious problem in adopting a value investment approach these days, and that’s unfortunate because in my opinion, it is the only approach that works.
So what should investors do about this? I think they should look at bank stocks. This will seem dramatically strange at first sight, because banks own hardly anything at all that is tangible. However, we already saw above that this is true for all companies now, so it can’t be avoided. The key point though is this: there is a well-determined market value for everything owned by a bank.
If you look at the balance sheet for Deutsche Bank, for example, you will see a very large number of items. They will all have market values though. That will be true of shares, bonds, interest rate swaps, credit default swaps, loans to corporates, futures and options, office buildings, warrants, cash in various currencies and any of the other myriad financial assets. There will also be a certain amount of brand value but I think that will be fairly low in the mix. So basically everything owned by Deutsche Bank could be turned into cash, and a known amount of cash, quite quickly.
Banks typically traded at 2.0x book value before the crisis. The rule of thumb for value investors in the sector was “buy at 1.0x book value, sell at 2.0.” Something like this is still true: you can buy Deutsche Bank at 0.3x book value and I think you should. That’s the right approach for value investors today.
There are two major investment styles which take completely different approaches.They are value investing and momentum investing.The former, also known as contrarianism, seeks to find cheap assets to buy.It is called contrarianism because often it involves looking for assets which are cheap because no one likes them.Momentum investing is simpler.This simply observes that often, assets that have been performing well continue to do so.So investors adopting this style just look for assets which have gone up and hope that they will continue to do so.
I favour value investing.One reason for this is because the problem with momentum investing is that assets which have done well continue to so until they don’t.There is no way to tell when something which has gone up will stop doing so.And we definitely know that nothing will appreciate forever!
The difficulty with value investing is knowing when an asset is cheap.In the early days of investing, the concept of book value was very useful.This is simply the accounting value.If a company owns a factory and some machinery, the book value will be close to the value for which the factory and the machines could be sold. If you can buy a share, or a slice of the company, for less than the book value per share, you should.
Book value is still very useful on many occasions.But modern companies are very complicated, and often much of what they do cannot be valued simply.A lot of their worth might be tied up in software, for example, which is harder to value than a building.Or they might own a lot of IPR — intellectual property which again, is intangible and hard to value.But the effort is worth it.Finding a cheap company to buy is one of the best ways to trade successfully.
I have written a lot about the importance of psychological factors in investing.It is absolutely crucial that you understand these, for two reasons.Knowing about your own psychology will help you understand and improve your decision-making processes. It will be especially valuable to know when cognitive biases are likely to cause you to make errors in evaluating investments.But just as important is knowing how other investors will think — after all, they have the same psychology as you do!And knowing what other investors are likely to think of an asset is the key.Because you want to find an asset which is not just cheap — but unjustifiably so.Then you can expect it to go up sustainably.
Psychologists study psychological capacities – what we the call “the mind.” One of the distinctive psychological capacities of human beings is the ability to explain and predict the behaviour and mental states of other humans. Psychologists call this ability “Theory of Mind”. We all have “Theory of Mind” – but how does it work? That is, by what method or mechanism do we explain and predict other people’s behaviour?
People are very good at predicting and explaining each other’s behaviour. We are so good at it, that often we do not realise we are doing it. And it is very unclear how we do it. In this post, I will briefly introduce some ideas in psychology about how we do it.
“Theory of Mind” is the label for how we predict and explain the behaviour of others. It was originally called that because the first idea was that we have a theory of other people. On this account, we learn this theory as children, or it is innate — meaning we are born with it. It ought to be something like a theory in that it has some kind of rules in a system. They would say things like “everyone who wants some ice cream will go where they think the ice cream is.”
Subsequently, there was a debate as to whether this was really the right explanation for our Theory of Mind. Alternative accounts emerged. This means that some new terminology was required. The account I have already outlined above, where people use a theory to predict and explain others, became known as Theory Theory. It was, if you like, the theory that using a theory is how we do Theory of Mind! We use rules to predict and explain the actions of others.
The challenger account was called Simulation Theory. This says that people predict and explain others by simulating them. In other words, I predict what you will do in a situation by imagining that I am in that situation and then deciding what I would do. I might think (implicitly probably) “I want some ice cream, where would I go?”
We can see that both methods produce results that look plausible, to begin with. Both of them would account for the way that if I say to you “why did Jimmy go to the ice cream van?,” you don’t have any difficulty coming up with what looks like a good answer. What we don’t know is whether you came up with that answer by using a rule (Theory Theory) or put yourself in Jimmy’s place (Simulation Theory).
The debate continues as to whether Theory Theory or Simulation Theory is correct. The major objection to Simulation Theory was that it could not explain cases of systematic Theory of Mind error. In the Stanford Prison experiment, for example, the participants acted much more harshly than anyone outside the situation predicted. Those objecting to Simulation Theory said that if it was the correct account of Theory of Mind, then we would be able to get the right answer. We would be able to correctly predict the harshness of the participants by imagining that we were there.
I have provided what I think is the only response to this objection. I call it the bias mismatch defence. In it, suggest that if there is a systematic error in Theory of Mind, like the one in the prison experiment, it is because the people in the experiment are acting under a common cognitive bias, and the people outside it are not. They do not simulate the bias, in other words. There could be several reasons why they do not simulate it. They might, for example, have no particular emotional involvement in the situation. After all, being outside prison is much less intense than being in prison!
In this particular case of the prison experiment, I think the bias in question is Conformity Bias. This is the way we all tend to do what we are told, to some extent. But I could use this bias mismatch approach much more widely. It could be used to explain any cases where people systematically fail to predict how experimental participants will react, if those participants can be seen to be exhibiting any cognitive bias. We know about more than 150 of those so far, so there is plenty of opportunity for bias mismatch to arise. This bias mismatch happens a lot I think, and it is why so many results in social psychology are interesting and surprising — and also why so often, we fail to understand others.
There have been claims recently that “collective Narcissism” explains some episodes where people behave in ways that are unexpected viz. elect Trump and vote for Brexit. If Narcissism is interpreted in the formal way that psychiatrists do, this can’t really be true. But, as I will explain, there are ways of constructing the claim such that it reveals some valuable insights.
The major objection to Simulation Theory has been that it cannot explain systematic errors in Theory of Mind. These are seen when people contemplate the infamous Milgram experiment, where everyone apparently gives out electric shocks to strangers, while everyone systematically fails to predict this.
I dealt with this objection in my book by positing “bias mismatch” as the answer. If the person you are simulating exhibits a cognitive bias and you don’t, your simulation will fail. For example, in the case of the Milgram Experiment, the bias you are not simulating is Conformity Bias. This is also known as the Asch Effect, and basically formalises the idea that we all tend to do what we we are told to some extent. This effect is surprisingly strong.
Obviously everyone exhibits Conformity Bias on occasions, but the observers do not exhibit it in the same way the participants in the experiment. in the experiment, the subjects are told very emphatically to proceed with the shocks, the experimenter is in a lab coat, it is the 1960s so a deference culture etc. So the effects of Conformity Bias are very strong. This type and intensity of Conformity Bias is not simulated by the observers and so they are surprised by the actions of the subjects.
Now we come to the Narcissism ideas, which I will situate in the above framework. The claim is that “collective Narcissism” about the greatness of a country causes people to make poor decisions. In the case of the US, they have elected someone who promised to make their country great again. In the case of the UK, they have decided to take huge unwarranted risks with the trade position without any particular upsides in the belief that the UK is better off alone.
The claim cannot really be that substantial numbers of people are actually suffering from Narcissistic Personality Disorder. This is because NPD subjects make up around 1% of the general population. This is quite common: many psychiatric disorders have around a 1% prevalence rate. I hypothesise that this is because if it is much less, we cannot see it, and if it is much more, we redefine it as normal!
So 1% of the population is not enough to elect a President or tilt a referendum. However, people can exhibit Narcissistic tendencies. This could be a much larger element of the population (data are sparse here). In order to look at the plausibility of that, let us consider what Narcissism looks like clinically. To help do that, I will now describe the criteria for a diagnosis of NPD.
Informally, Narcissism could be characterised as excessive self-regard, though it is perhaps unclear how one would characterise such excess and subjects can often be extremely successful high-status individuals. So in a sense, the high self-regard can be merited.
Formally, four criteria must be satisfied in order for a subject to receive a diagnosis of Narcissistic Personality Disorder. These are: impairments in self-functioning, impairments in interpersonal functioning, impairments in intimacy and antagonism. Each of the criteria can be exhibited in either of two ways.
Impairments in self functioning can be exhibited by excessive reference to others for self-definition and self-esteem; or goal-setting may be based excessively on the aim of obtaining approval from others.
Impairments in interpersonal functioning may be exhibited either by impaired empathy or by impaired intimacy. Empathy is defined as the ability to recognise or identify with the feelings and needs of others or a tendency to underestimate one’s own effect on others.
Impaired intimacy is seen if relationships are largely superficial and exist to mostly serve the ends of the subject.
Finally, a diagnosis also requires antagonism, which may be characterised either as grandiosity, meaning feelings of entitlement or self-centredness, or attention-seeking behaviour.
So here we see how everything fits together. I think we can agree that many more people than 1% of the population could exhibit tendencies like the above. I also think we can regard Narcissistic tendencies, which would look like the above but fall short of being fully diagnosable, as a cognitive bias. This could be much more widely prevalent in the population than the number of diagnosable subjects. If you simulate such people and you do not yourself have the same Narcissistic tendencies about the same issues, you will get it wrong. So we see how the claims that Narcissistic tendencies can explain our failure to predict the explanation of Trump and Brexit, despite abundant data pointing that way, can be because of our failure to account for something like collective Narcissism in others.