The Behavior Gap: Trend Following Principle

You see them. Maybe you are one. Some are so connected to their BlackBerry, they can’t imagine it not being in their hand 24/7. Compulsive gaming. Second Life. Sparknotes. People are looking at screens, sometimes multiple screens. Some think teaching students to multitask is important for future jobs. Jobs doing what? Serving Ritalin with a splash of Patron?

Attention deficit disorder is so pervasive, and so ubiquitous, that very few of us even see it as a major concern. People are supremely distracted, and that equals behaviors driven by the moment. Not behaviors purposeful and thought out.

While making a documentary film (brokemovie.com), one of the first places my crew visited was a sheep farm. Those animals were so scared to be separated from the group it is terribly hard to put their fear into words. Late in the day of the shoot, I got really close to the herd and tried to split them in half. They panicked to reform their group. They had to get back to one cohesive crowd. They made no sounds. Their faces were expressionless. They just moved their feet, and moved them fast.

Humans live to be part of a group too: The group offers safety, confirmation, and simplifies decision-making. Further, if something goes wrong, it is far more comforting to be with others than to be alone. The old saying, “Misery loves company,” rings true. However, the successful trader has to be willing to separate from the crowd to be a contrarian, even though their might always be a strong emotional urge to stay with the group.

Additionally, human sheep behavior is shaped further by a proliferation of electronic goodies. Greed, hope, fear, denial, herd behavior, impulsiveness, and impatience are jacked up on gadget steroids. This is a recipe and foundation for manias and bubbles ad infinitum (source: Charles Faulkner).

Daniel Kahneman, the first psychologist to win the Nobel Prize in Economics, attributed market manias to investors illusion of control, calling this illusion Prospect Theory. He wanted to know: How do people estimate odds and calculate risks? The short answer: Not smartly (source: Jason Zweig, Do You Sabotage Yourself? Business 2.0, May 2001).

People dislike losses so much that they will make nonstop irrational decisions in vain attempts to avoid the pain. This explains why traders, for example, sell winners too early but hold on to losers too long. It is human nature to take profit from a winner quickly on the assumption that it will not last for long, but stick with a loser in the hope it will bounce back (source: David Dreman, Contrarian Investment Strategies. New York: Simon & Schuster, 1998). The typical trader acts on the law of small numbers, basing decisions on statistically insignificant examples. For instance, if you buy a fund that has beaten the market three years in a row, it is easy to become seduced that it’s on a hot streak. It is hard for us to stop overgeneralizing. Limited empirical evidence is what drives life these days (source: Jason Zweig, Do You Sabotage Yourself? Business 2.0, May 2001).

Any discussion of why traders are their own worst enemies starts with sunk costs. A sunk cost is a cost incurred you cannot retrieve. Although sunk costs should not affect your current decisions, people have a tough time leaving the past. Some will buy more of a losing stock just because of their initial decision to buy it. You can say proudly, “I bought on a discount!” Or, “I got it cheap.” Of course, if that stock goes to zero, your theory dies. Unfortunately, many are ambivalent to sunk costs. Intellectually, you might know that there is nothing you can do about money already spent, but emotionally dwelling on it is standard operating sheep deportment.

An experiment with a $10 theater ticket illustrates this. One group of students was told to imagine they had arrived at a theater only to discover they had lost their ticket. Would they pay another $10 to buy another ticket? A second group was told to imagine that they were going to a play, but had not yet bought a ticket. When they arrived at the theater, they realized they lost a $10 bill. Would they still buy a ticket? In both cases, the students were presented with the same question: Would you spend $10 to see the play? Eighty-eight percent of the second group, which had lost the $10 bill, opted to buy the ticket. However, the first group, the ticket losers, focusing on sunk costs, asked the question differently: Am I willing to spend $20 to see a $10 play? Only 46 percent said yes (source: Steven Pearlstein, The New Thinking About Money Is That Your Irrationality Is Predictable. The Washington Post, January 27, 2002, H01).

What are some additional behaviors that virtually guarantee losses in the markets?

  • Lack of discipline: It takes an accumulation of knowledge and sharp focus to trade successfully. Many would rather listen to the advice of others. They just want to believe, like Fox Mulder.
  • Impatience: Some have an insatiable need for action. The day trading adrenaline rush and the gamblers high can have heroin-like addiction pull.
  • No objectivity: Some are unable to disengage emotionally from the market. They create a virtual lifelong marriage to their trades. Divorce is not an option.
  • Greed: A desire for quick profit blinds many from the diligent work needed to actually win in the long run.
  • Refusal to accept truth: Some do not want to believe that the only knowable truth is price action. They feel more secure following cult leaders serving Kool-Aid.
  • Impulsive behavior: Many jump into investments based on the morning paper or Good Morning America. Thinking that if you act quickly, somehow you will beat everybody else in the great race is a recipe for a messy failure.
  • Inability to stay in the moment of now: To be a successful trader, you cannot spend your time thinking about how you are going to spend your profits. Trading because you have to have money is not workable.
  • Stay open-minded: Come into the day knowing your future steps. Do not be stubborn when the market does not go your way. Cut your losses and follow your stinking trading plan.
  • Avoid false parallels: Just because the market behaved one way in 1995, 2000, or 2008 does not mean a similar pattern today will give you the same result. A great example of this: The Hindenburg Omen. It is a technical analysis pattern that is said to portend a stock market crash. The problem: Sometimes it is right, sometimes not. You don’t want to bet your life savings on a coin flip.

These behaviors all remind us that unlike in the animal world, where a threat passes quickly, humans live in constant stress. For 99 percent of animals, stress is about three minutes of screaming terror and the threat is over. We turn on the exact same stress response when pondering 30-year mortgages. What is quickly emerging as the biggest public-health problem everywhere? Depression (source: Harris Collingwood, The Sink or Swim Economy. The New York Times, June 8, 2003).

You want to avoid that fate? Golf legend Jack Nicklaus is famous for saying: “Dont be too proud to take a lesson. I’m not. Learn the fundamentals of the game and stick to them. Band-Aid remedies never last.” The fundamentals of the trend following game include behavior. Take a quote from a blog in the New York Times for example:

People take comfort in doing what everyone else is doing, and if they are wrong, at least they are wrong with others.

IQ vs. EQ

Many believe academic intelligence is the direct path to reaping a fortune. Some literally tout their IQ as if their IQ is money in their bank account. One longtime trend follower drilled that nonsensical stance: “I haven’t seen much correlation between good trading and intelligence. Some outstanding traders are quite intelligent, but a few are not. Many outstandingly intelligent people are horrible traders. Average intelligence is enough. Beyond that, emotional makeup is more important.”

In an interview with one legendary trader, it struck me how he chose to begin. He opened by saying that when he was in kindergarten, he failed blocks. That humor is from a man worth north of 100 million. He is smart, but his point: IQ is no magic elixir. Not only do people fall into the IQ equals success trap, they fall prey to thinking that a degree will take them to the top. That’s 100% not true (see the book Linchpin for more). In fact, recent research taken from http://finance.yahoo.com, takes my point further:

[Look at] the livelihoods of plumbers and doctors. Yes, doctors have a bigger salary. But, doctors have to endure nearly a decade of expensive education before making any real salary, after which the doctor is hit by a very high progressive tax rate. Because of all the costs the doctor incurs, the taxes and the lost wages…plumbers make more, and have almost the same spending power over their lifetime as general practitioners.

Consider those who pursue academic PhDs. A PhD is a specialist, not a generalist. In the real world, not the academic one, the generalist is todays winner. Not all PhDs are motivated entrepreneurial competitors capable of killing it (of course there are exceptions). A PhD, or any degree, does not protect you from failure. A degree says more than anything that we passed the test.

My comments are no knock against degree winners, but they are a reminder that it is you against the world. If you have a degree, any degree, that’s awesome. I have three letters behind my name, but so what? Dont use the degree on the wall billboard, circa 1950s Leave it to Beaver America, to imply you are special.

Those days are long gone…or maybe not! Credentialism is the short cut that relieves people from thinking. The Associated Press recently ran with this frightening slug line:

New York: Todays college students are more narcissistic and self-centered than their predecessors, according to a comprehensive new study by five psychologists who worry that the trend could be harmful to personal relationships and American society. Stop endlessly repeating “You’re special,” and having children repeat that back. Kids are self-centered enough already.

I see those kids everyday, most are adults! Some of the factors that will influence how well you do in life include self-awareness, self-discipline, intuition, empathy, and an ability to enter the flow. These traits are particularly useful for garnering profits from the markets. Yet many stay preoccupied on other facets of trading, even when leaving the mental part out is guaranteed long-term failure (source: Daniel Goleman, Emotional Intelligence. New York: Bantam, 1995).

This is not easy. Biological impulses are drivers of our emotions. There is no way to escape that fact, but you can learn to self-regulate your feelings and, in so doing, manage situations where emotions can interfere with sound decision-making like in the markets. Self-regulation is the ongoing inner conversation that emotionally intelligent people engage in to not be a prisoner to their feelings (source: Daniel Goleman, What Makes a Leader? Harvard Business Review, 1998).

The ability to delay gratification, stifle impulsiveness, and shake off the inevitable setbacks and upsets is critical. Without emotional intelligence, you can have superior trend following training and systems, using an incisive and analytical mind with infinite creativity, and still fail (source: Daniel Goleman, What Makes a Leader? Harvard Business Review, 1998).

How can you start down that right path? The path to accepting the emotional part of your consciousness means focusing on improving your happiness. Here are some tips from James Montier:

  • Do not equate happiness with money. You will acclimate quickly to shifts in income, but long-lasting benefits for all of us are negligible.
  • Regular exercise generates energy and stimulates mind and body. Justdo it.
  • Having sex, preferably with someone you love, is often rated among the highest generators of happiness.
  • Close relationships require serious work and effort, but pay huge rewards.
  • Take time to appreciate the good things in life, a very simple habit that will help keep you from trouble.
  • Seek work that engages your skills. It makes sense to work at something you enjoy.
  • Sleep. Eight hours. Mandatory.
  • Take control of your life and set achievable goals.

Follow all rules and please dont ask if these are relevant to trend following success.