The Science of Irrationality

A Nobelist explains our fondness for not thinking

By JONAH LEHRER

Here's a simple arithmetic question: "A bat and ball cost $1.10. The bat costs $1 more than the ball. How much does the ball cost?"

The vast majority of people respond quickly and confidently, insisting the ball costs 10 cents. This answer is both incredibly obvious and utterly wrong. (The correct answer is five cents for the ball and $1.05 for the bat.) What's most impressive is that education doesn't really help; more than 50% of students at Harvard, Princeton and the Massachusetts Institute of Technology routinely give the incorrect answer.

Daniel Kahneman, a Nobel Laureate and professor of psychology at Princeton, has been asking questions like this for more than five decades. His disarmingly simple experiments have profoundly changed the way that we think about thinking. While philosophers, economists and social scientists had assumed for centuries that human beings are rational agents, Mr. Kahneman and his scientific partner, the late Amos Tversky, demonstrated that we're not nearly as rational as we like to believe.

When people face an uncertain situation, they don't carefully evaluate the information or look up relevant statistics. Instead, their decisions depend on mental short cuts, which often lead them to make foolish decisions. The short cuts aren't a faster way of doing the math; they're a way of skipping the math altogether.

Although Mr. Kahneman is now widely recognized as one of the most influential psychologists of the 20th century, his research was dismissed for years. Mr. Kahneman recounts how one eminent American philosopher, after hearing about the work, quickly turned away, saying, "I am not interested in the psychology of stupidity."

But the philosopher missed the point. The biases and blind-spots identified by Messrs. Kahneman and Tversky aren't symptoms of stupidity. They're an essential part of our humanity, the inescapable byproducts of a brain that evolution engineered over millions of years.

In Mr. Kahneman's important new book, "Thinking, Fast and Slow," his first work for a popular audience, he outlines the implications of this new model of cognition. What are the most important mental errors that we all make? And can they be overcome?

Consider the overconfidence bias, which drives many of our mistakes in decision-making. The best demonstration of the bias comes from the world of investing. Although many fund managers charge high fees to oversee stock portfolios, they routinely fail a basic test of skill: persistent achievement. As Mr. Kahneman notes, the year-to-year correlation between the performance of the vast majority of funds is barely above zero, which suggests that most successful managers are banking on luck, not talent.

This shouldn't be too surprising. The stock market is a case study in randomness, a system so complex that it's impossible to predict. Nevertheless, professional investors routinely believe that they can see what others can't. The end result is that they make far too many trades, with costly consequences.

And it's not just investors who suffer from this mental flaw. The typical entrepreneur believes that he or she has a 60% chance of success, though less than 35% of small businesses survive more than five years. Meanwhile, CEOs who hold more company stock—taken here as a sign of self-confidence—also tend to make more irresponsible decisions, overpaying for acquisitions and engaging in misguided mergers.

Even consumers are hurt by this bias. A recent survey of American homeowners found that they expected, on average, to spend about $18,500 on remodelling their kitchens. The actual average cost? Nearly $39,000.

We like to see ourselves as a Promethean species, uniquely endowed with the gift of reason. But Mr. Kahneman's simple experiments reveal a very different mind, stuffed full of habits that, in most situations, lead us astray. Though overconfidence may encourage us to take necessary risks—Mr. Kahneman calls it the "engine of capitalism"—it's generally a dangerous (and expensive) illusion.

What's even more upsetting is that these habits are virtually impossible to fix. As Mr. Kahneman himself admits, "My intuitive thinking is just as prone to overconfidence, extreme predictions and the planning fallacy as it was before I made a study of these issues."

Even when we know why we stumble, we still find a way to fall.

Know thyself

The noise across the venture investing landscape is deafening. Is there a valuation bubble? Is the boom in angel investing about to tip? Should large venture funds be doing seed stage investing? Is small-ticket Micro VC a legitimate strategy? Can new venture managers get funded? Blah, blah, blah. Bottom line: I don’t care and neither should you.

Whether you are building a new business, investing as an angel or deploying the capital of others, the guiding principles are the same:

1. Have a plan
2. Speak to lots of smart people about the plan
3. Iterate the plan
4. Execute the plan
5. Constantly critique the plan
6. Adjust the plan as necessary
7. Rinse, repeat

In short, know thyself and stay true to the mission. Just because someone else’s mission looks cooler and more successful than yours doesn’t mean that yours sucks; it may just take longer to play out. And if you try and adopt someone else’s mission, odds are that people will know you’re faking it and lack the true passion necessary for its successful execution. And if your mission, over time, proves to truly suck, then it’s time to ditch the mission and reassess: the market has spoken.

There is a huge difference between incorporating the feedback of smart people while preserving your core philosophy and changing missions as the wind blows. I can tell you that such a lack of rootedness will invariably lead to failure. Whether a business builder, an investor or both, it takes maniacal focus, passion and intensity to be successful. Only you can find your way; you simply can’t dial in the mission.

Worried about the macro environment? If you’re a company then raise 2-years of cash, not 9-12 months. If you’re a fund, make sure you are properly reserved for a hostile fund-raising environment where you’ll need to step up and support your companies until the market thaws. Otherwise, you’ll likely get jammed in pay-to-plays and get flushed at the worst possible time. These are things you can plan for and they don’t involve rocket science. Just plain good judgment and planning. It is perfectly reasonable to take a different view and be more aggressive, either by raising less and taking less dilution now (if a company) or by making more investments with lower or no reserves on the theory that the strong start-up market will continue to run (if you’re an angel or a fund). As long as you go in eyes wide open, I’m cool. You might get carried out in the end, but you took a calculated risk and lost. In my book that’s fine. Unfortunate, but fine. You proactively made the decision and followed through.

In short, I think both founders and investors are, in many cases, paying way too much attention to reverberations within the venture echo-chamber instead of just making good, sensible plans consistent with their missions. If a certain set of investors don’t like it, too bad. Find some others. If LPs don’t like your approach? Either take friends-and-family money or execute your plan as an angel and prove out your thesis. It’s within your control. Don’t cede control of your destiny to the oscillating waves of popular thought. Who cares what’s popular? Often what’s popular today falls out of favor tomorrow, so giving up on what looks like a contrarian strategy might be the worst decision you could possibly make.

Every trader must believe in God.

Written on October 17, 2011 by Eli Radke

 

Ok, not God but you have to have a believe in something you can’t always see, profits and progress. This is a big problem I see with traders. Either they are new to trading or they have gotten beat up in the past. They do not know what hard work is or how to not self destruct. They are uncommitted.

Hard work (new trader)

They see other people making money and they think it is easy. It takes awhile to become an overnight success. It takes even longer if you start from scratch and without help. I am perplex to find that many traders have not done the first thing required to be successful, a trading plan. We define a trading plan as a set of rules applied to a strategy. However you define it; it should shift the focus away from you and unto the market, answer the questions the market answers, and strategy must be repeatable and improvable. If you do not have plan it is hard to make money because you are always doing random things for random reasons, there is no constant and every experiment needs a constant.

Self destruction (older trader)

A trader can be his own best friend or worst enemy. At some point he will become his own worse enemy. Undoing days, weeks, or months of psychological and financial progress in a single trading session. When you lose “too much” , you probably have not stopped losing. Take a deep breathe when you are hurting, take some time away. I said it before but the bad does become worse with frightening regularity. When it is hardest to be discipline, it is the most important time to do so. As my mentor always told me, be able to trade tomorrow whenever tomorrow is.

Why belief is important.

You have to be committed to accomplish anything that is a difficult. There are times when it is going to be bad. There are times when you have to pick yourself up. There are going to be times when you figure it all out and it changes the next day. There are many times when you are going to question whether it is worth it, if you are asking that question the answer is always no. It is not worth it; you have not reached your goal, yet. The better question is, will it be worth it? You can’t be half pregnant when it comes to trading, in the times when you are in front of the screen you have to be 100% committed.

If you are new, believe the work you are doing has value. If you have lost a lot, that is in the past and believe you will put yourself in a situation to make it back. In order to sustain belief you have to see progress but to progress you need to start with belief. Does God exist, I am not sure. Do I believe in God, yes I do. The problem with not believing in God is that you may be wrong. Upside of believing in God is you might be right, if not you are dead anyways. Trading is the same, yes you are going to have to do some extra work but it beats the alternative which is not giving yourself a chance.

Do You Know Your Edge?

Obviously, you need an edge with your trading methodology or you’re not going to make it. If you haven’t back-tested it or cannot articulate it, you may not have one. But many traders who do happen to have an edge with their methodology are still not performing well. I sometimes refer to this as the ‘profit gap’ – the difference between your plan/method and your actual results. As a trading psychologist and an active trader myself I have a different view of “edge”.

As traders, we use logic and data and a method to justify our decisions, and we spend lots of time looking at charts….but at the crucial moment, where the rubber meets the road, it’s our emotions/feelings that actually provide the fuel to pull the trigger or not, whether it’s an entry or an exit, a winner or a loser. See my recent webinar where I show why your emotions can not be ignored and how they play an important role in your trading decisions.

The reality in trading is that you are your own edge. It’s in the gray matter between your ears. More specifically, your edge is your ability to adapt to whatever you see in the market. Call it cognitive flexibility, or whatever you want, but this is the reality of trading.

For example, when it comes to entries, one’s ability to adapt is critical, especially for the discretionary trader, because set-ups often don’t look neat and clean. Mixed signals and some degree of ambiguity are common. Ability to tolerate ambiguity is a psychological skill. Part of your personal edge.

And when it comes to exits, adaptability is even more critical. While entries and trade location are important, its ultimately your exits that will determine how much success you experience as a trader. Dealing with losers effectively and maintaining flexible expectations is a function of adaptability, your personal edge.

Trading involves a lot of disappointment (entries are not always perfect, targets not always reached, we exit and then see it go on to work, etc), and that disappointment often puts traders on tilt causing emotions to trump will power, paving the way for traders to veer from their plan and break their rules. Resilience in the face of disappointment is your personal edge.

Most people focus on what causes the market to move, but the harder part of trading is knowing what causes YOU to move. Once you have a handle on understanding on what causes the market to move you need to work on understanding yourself to know what causes you to move. This is how is how you develop your personal edge.

Was not able to post this week and the market (YM) made an unusual move as shown from this 60-min. chart.

It drops more than 200 points last Monday and move up a little bit early Tuesday, then stays sideways for three days.

It went up today, Friday, the last trading day.

Not quite a tradeable week for the traders.

Adjusting Day Trading Strategies For Different Market Conditions

For active stock traders, having different strategies for different market conditions is a crucial factor. Trends emerge, fade, reverse and ranges develop, all playing out in ever broader trends and ranges, all within a single trading session. Thus, the trader is faced with a choice: trade one strategy and profit only at times that suit the strategy, or trade several strategies that allow them to trade profitably, in an array of market conditions. Different times of the day pose different opportunities and threats, and must be accounted for. Once several strategies have been adopted, it is crucial that the trader know when to implement each type of strategy.

Three Types of Trading Strategies

For day traders, strategies will generally fall into three types of categories: scalping, trending and ranging. "Scalping" includes all trades where the trader is trying to capture a profit on order flow, such as making the spread, collecting ECN credits or riding the coat tails of a large order. "Trending" includes all strategies where the trader attempts to profit from a sustained move in one direction. Lastly, "r anging" strategies are used when the market is moving back and forth between resistance and support; profits are made inside this band, instead of on a stock making new highs or new lows (as in trends).

All traders will benefit from having trending strategies and range trading strategies in their arsenal. These are then combined with scalping strategies, to provide methods which are more likely to be profitable at all times of the day.

Adapt Strategies to Time of Day

The morning, lunch hour and afternoon are very different, and require different strategies.

The morning is volatile and big moves occur quickly. This means a trending type strategy is likely better. The trader may have to aggressively enter (remove liquidity) positions in order not miss out on the largest and/or quickest moves of the day.

The lunch hour, between 11:00 a.m. and 1:00 p.m. EST, is usually a quieter time. The market generally has a more ranging quality to it; moves are smaller, volume has decreased and big money is not aggressively moving stocks. This is a time where traders should focus on adding liquidity at the extreme edges of the established range, or even slightly outside. Trades should only be taken with a very high probability of success. While there are exceptions, most days will not require removal of liquidity to enter positions, during this time. Rather, traders should wait for the price to come to where they want and if it doesn't, don't make the trade. Due to the fact that there is less volume, and trades are likely to last longer than in the morning or later in the day, traders should make sure their reward/risk compensates them for this. Thus, trades will likely be few during this time.

As traders return from lunch and the close is within sight, volume and movement usually pick up. This will occur anytime from 1:00 p.m. EST. Continuing with the noon time strategy of being very selective on entry points, the trader will be wary that trends may once again start to emerge. Breakouts from lunchtime ranges can be swift and aggressive, therefore, exit losses quickly and move to a trending strategy. Patience is still required here. Exit losses quickly and attempt to see where the trend is going, towards the close. Remove liquidity if required, but since moves may still be questionable, add liquidity when possible, until definitive trends emerge.

The three times of day can be summed up by the aggression style that should be used to trade them:

• Morning – Aggressively join momentum moves that are starting. Removal of liquidity is often required. Use tight stops, as a change in direction can happen swiftly.
• Noon – Very conservative. Use range trading type strategies. Always try to add liquidity, unless a loss is escalating. Be very patient, let price come to the order, instead of removing liquidity to enter a position.
• Afternoon – Watch for breakouts of lunchtime range, if there was one. Join trending moves, attempting to add liquidity if markets remain quiet. Exit noon trades quickly, if the price moves against those positions in the afternoon. Look for points where the morning trend is likely to re-emerge or reverse.

When to Shift Strategies

The times of day are only rough approximations; what really matters is noticing when the market shifts from ranging to trending and vice versa, then adjusting to it. When this shift is occurring, is much easier to see if charts are continually updated with trendlines, and horizontal support and resistance lines, as shown in Figure 1.

Figure 1 – General Electric (GE) 5 Minute Chart – July 13, 2011

Source: ThinkorSwim – TD Ameritrade

In the morning, there is high volume at the open, which even increases as the trend accelerates. In order to take part in a move such as this, the trader needs to be aggressive, removing liquidity to get on board with the trend. The trader can add liquidity to capture a retracement, but may miss the swiftest move of the day.

As the day progresses, by 11:00 a range has established, with an upward bias and a false breakout occuring at 11:30. At this point in the day, though, a trader should be less aggressive, adding liquidity and focusing more on a range-type strategy, until the market gives signals otherwise. Volume is declining and false breakouts are a high probability, therefore, this breakout is more likely to be "faded," than to be seen as the continuation of a trend.

At just after 13:00 the market breaks lower. Volume remains low, so there is no need to get aggressive on entering; however, if the trader is long they should look to exit immediately, as trends can develop quickly after lunch. Through the afternoon the trader combines patience and a trend following strategy, if a trend develops; otherwise they will stay with the conservative ranging strategy, waiting for entries (potentially on pullbacks) into the overall trend.

By drawing trendlines and horizontal support and resistance, the type of environment the stock is in will be much more visible. As exemplified in the chart, trendlines should be drawn and when that trend line breaks down, a horizontal line should be drawn at the most recent swing high and swing low. In this way, we can see if a trend is reversing, or simply entering a ranging period. Horizontal lines can also be drawn during trends at reversal points; this will aid in seeing if the trend is slowing or potentially entering a range. During a range, a trendline can be drawn if price movements are biasing one direction, as we see in Figure 1 from 10:30-11:30 a.m. EST.

The Bottom Line

Day traders can benefit from having multiple strategies for different market conditions. Being able to range and trend trade successfully, will allow the trader to profit more readily, as well as know when to be aggressive (remove liquidity) and when to let price come to them. When trading multiple strategies, a trader must know the times when a particular strategy is likely to be the most useful. By continually marking the stock chart with recent price highs, price lows and trendlines, a deeper understanding of what stage the market is in, will be attained and, thus, what type of strategy to use.

 

The Rise Of The Rogue Trader

 

Amy Fontinelle, On Monday October 17, 2011, 4:29 pm EDT

With the recent scandal in which trader Kweku Adoboli lost 1.3 billion pounds for his employer, the Swiss investment bank UBS, rogue traders have been in the news. A rogue trader is a trader who takes unauthorized investing risks to attempt massive gains, but makes reckless choices in the process. These professionals may work as fund managers, at trading desks or in other capacities where they can invest large amounts of other people's money.

Playing by Their Own Rules

What makes these traders "rogue" is their unethical behavior. They may act without the authorization of their companies or supervisors, or exceed the limits they are given. Their investment styles might be more accurately described as speculating, betting or gambling. They may use enormous amounts of leverage or take high-risk positions in derivatives or currencies. Rogue traders often seek huge profits for themselves, but these individuals' professional positions and trading behavior, not their motivations, are what define them as rogue traders.

Rogue traders are usually willing to circumvent government regulations and company rules. These traders might initially be successful and emboldened by their results. They may take larger and larger risks to maintain or improve their track records. Ultimately, their risky bets can cause major losses for the companies they work for and bring criminal charges for fraud, collusion, breach of trust and more. These charges can bring jail time and fines to rogue traders.

Rogue Traders In Recent History

Over the last 20 years, we've seen a handful of major rogue trading scandals. In 1992, Harshad Mehta and other brokers colluded to manipulate the Bombay Stock Exchange. In 1995, Nick Leeson incurred a $1.4-billion loss for Barings bank that brought down the centuries-old institution. Trader Jerome Kerviel incurred a $7-billion loss for French bank Societe Generale, the largest uncovered thus far. Other rogue traders have been caught in Japan, the United States, Australia and the United Kingdom. There may be more rogue traders than we know about. Those who have been successful or who have avoided getting caught in unauthorized or illegal trading activities might be considered investment superstars or be quietly going about their business.

Some rogue traders are infamous not just for their scandalous trading behavior, but for their personal behavior. Stockbroker Jordan Belfort, the "Wolf of Wall Street," was convicted of money laundering and fraud in a relatively small pump-and-dump scheme that lost $200 million, but he is also known for reckless and outlandish acts, including organizing a trading floor midget-throwing contest, using massive quantities of illegal drugs and destroying a yacht and other vehicles.

A Rogue Trader's Downfall

A sudden, major loss usually triggers a rogue trader's demise. Complex trading strategies can go bad when something unexpected happens in the markets. In Leeson's case, nature intervened. A short straddle he placed on the Nikkei became a huge loss after an earthquake in Kobe.

Rogue traders might also be caught if a co-worker reports their behavior or if regulatory authorities catch on, as happened with Peter Young and an SEC investigation. An exchange may notice a particular trader's behavior or be tipped off, which occurred in the case of Jerome Kerviel and the Eurex derivatives exchange. Adoboli tried to hide his massive losses, but got caught falsifying accounting records.

The Fallout of Rogue Trading

A single rogue trader can bring down an entire company, no matter how well established it is or how successful it has been in the past. A rogue trader's influence can easily extend outside of his or her company. When a rogue trading scandal comes to light, it can cause a major drop in the share price of the bank or investment company associated with the scandal, which happened in September with UBS. Furthermore, a company with a tarnished name may have trouble retaining existing clients and attracting new ones. Top executives can also be forced out of the company for their failure to catch the problem before it exploded, or as part of a company's attempt to regain the public's trust.

The Bottom Line

Losses from rogue trading can be far reaching and extend worldwide. In the aftermath, victims and fearful onlookers may call out for increased government regulation, such as the recent suggestion to ban ETFs, in an attempt to prevent the next fraud. Regulations cannot put a stop to human ingenuity or fallibility. It will only be a matter of time before the next rogue trading scandal emerges.