The greatest emotional problem facing traders

Research reviewed by Scott Plous in his book “The Psychology of Judgment
and Decision Making” suggests that overconfidence is greatest in situations
where individuals have no better than chance odds of being correct in their
judgments. One of the reasons for
this is called the Gambler’s Fallacy. A
person who guesses market direction once a day and has a 50/50 chance of being
correct will encounter, on average, about six occasions per year in which he or
she is correct five times in a row. Some
of these random traders will, by sheer good fortune, hit this streak early on in
their career. According to
researcher Ellen Langer, early (but random) experiences of success lead
individuals to be highly confident in their ability–even when the task is
guessing the outcome of coin tosses! This
is because they are more likely to attribute success to internal
factors–skill–than to situational reasons or chance.
The gambler who experiences a (random) streak of wins becomes convinced
that he has a hot hand and raises his bets accordingly.
The result is predictably disastrous.

Do traders behave differently from gamblers?
Research suggests not. Terence Odean found that traders who were most confident in their decision-making traded
the most frequently–and lost more money than other traders because of the
increased transaction costs. A
provocative study from the London Business
School

presented traders with price data and asked the traders to make trading
decisions based on the data. Traders
were not informed that the data were generated randomly.
The traders who expressed the greatest confidence in their decisions, not
surprisingly, were also the ones who, on average, lost the most money.
The “illusions of control” demonstrated by these traders can reach
extremes bordering on the absurd. In
Langer’s studies in which coin tosses were presented as tests of “social
cues”, for instance, 40% of all subjects insisted that their ability to guess
the outcome of the coin tosses could be improved with practice–and 15%
believed that enhanced concentration and an absence of distractions would
improve their results.

A different kind of overconfidence can be seen in surveys of traders and
investors, asking them for their expectations for the market.
Traders feel better about their ability to call market direction than is
warranted. For example, in such
surveys as those conducted by Investors Intelligence, over 70% of respondents
pronounce themselves either bulls or bears–despite the fact that the majority
of time the market is range bound. Research
cited by Hersh Shefrin, in his review of behavioral finance studies entitled Beyond
Greed and Fear, finds that traders are most bullish after extended
rises–with inexperienced traders most bullish of all.
That is paradoxical, because market returns historically have been
greatest following years of decline, not years of strength.
Similarly, it is not uncommon to see put-call ratios elevated after a
five-day period of decline, despite the fact that returns, on average, are
superior following five days of weakness than after five strong days.
Quite simply, traders extrapolate from the past to the future–and
confidently act upon these (false) expectations.

Is it possible to immunize oneself from overconfidence?
My personal therapy for treating overconfidence has been to test out my
trading ideas and calculate: a)
precisely how often the pattern would have been successful if used in the past;
and b) how much of a P/L edge was present over that time.
Those statistics, which I report on my blog, ground me in the inherent
uncertainty of markets and prepare me for the very real possibility, with any
trade idea, that I will be wrong. This,
in turn, has helped me greatly with risk management, as I am unlikely to wager a
large proportion of my trading stake on any uncertain proposition–even when
the odds are in my favor. The past
is hardly a guarantor of the future, but by assuming that the future won’t be better
than the past, we can soberly assess the downside and avoid overconfidence.

The best trades, I find, have enough of a historical edge to make me feel
confident about the idea, but also enough potential downside to prevent me from
feeling overconfident. Planning for
each trade being a potential loser may seem counterintuitive, but it keeps risk
management sharp and overconfidence at bay.
And that makes a world of difference to the bottom line.

Brett N. Steenbarger,
Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY
Upstate Medical University in Syracuse NY and author of The
Psychology of Trading (Wiley, 2003). As Director of Trader
Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training
program for traders. An active trader of the stock indexes, Brett utilizes
statistically-based pattern recognition for intraday trading. Brett does not
offer commercial services to traders, but maintains an archive of articles and a
trading blog at www.brettsteenbarger.com
and a blog of market analytics at www.traderfeed.blogspot.com.
His book, Enhancing Trader Development, is due for publication this fall
(Wiley).