Human emotion is both the source of opportunity in trading and the greatest challenge. Master it and you will succeed. Ignore it at your peril.

To trade well you need to understand the human mind. Markets are comprised of individuals, all with hopes, fears and foibles. As a trader you are seeking out opportunities that arise from these human emotions. Fortunately, some very smart people—behavioral finance pioneers—have identified the ways that human emotion affects one’s decision-making process. The field of behavioral finance—brought to popular attention in Robert Shiller’s fascinating book, now in its Second Edition, titled Irrational Exuberance and greater details of which were published by Hersh Shefrin in his classic Beyond Greed and Fear—helps traders and investors understand the reasons why markets operate the way they do. Just what does make prices go up and down? (Price movements can turn an otherwise stoic individual into a blubbering pile of misery.)

Behavioral finance is able to explain market phenomena and price action by focusing on the cognitive and psychological factors that affect buying and selling decisions. The approach has shown that people are prone to making systematic errors in circumstances of uncertainty. Under duress, people make poor assessments of risk and event probabilities. What could be more stressful than winning or losing money? Behavioral finance has proved that when it comes to such scenarios, people rarely make completely rational decisions. Successful traders understand this tendency and benefit from it. They know that someone else’s errors in judgment are opportunities, and good traders understand how those errors manifest themselves in market price action: The Turtles knew this.

Emotional Rescue

For many years economic and financial theory was based on the rational actor theory, which stated that individuals act rationally and consider all available information in the decision-making process. Traders have always known that this notion is pure bunk. Winning traders make money by exploiting the consistently irrational behavior patterns of other traders. Academic researchers have uncovered a surprisingly large amount of evidence demonstrating that most individuals do not act rationally. Dozens of categories of irrational behavior and repeated errors in judgment have been documented in academic studies. Traders find it very puzzling that anyone ever thought otherwise. The Turtle Way works and continues to work because it is based on the market movements that result from the systematic and repeated irrationality that is embedded in every person. How many times have you felt these emotions while trading?

• Hope: I sure hope this goes up right after I buy it.

• Fear: I can’t take another loss; I’ll sit this one out.

• Greed: I’m making so much money, I’m going to double my position.

• Despair: This trading system doesn’t work; I keep losing money.

With the Turtle Way, market actions are identified that indicate opportunities arising from these consistent human traits. This chapter examines specific examples of how human emotion and irrational thinking create repetitive market patterns that signal moneymaking opportunities.

People have developed certain ways of looking at the world that served them well in more primitive circumstances; however, when it comes to trading, those perceptions get in the way. Scientists call distortions in the way people perceive reality cognitive biases. Here are some of the cognitive biases that affect trading:

• Loss aversion: The tendency for people to have a strong preference for avoiding losses over acquiring gains

• Sunk costs effect: The tendency to treat money that already has been committed or spent as more valuable than money that may be spent in the future

• Disposition effect: The tendency for people to lock in gains and ride losses

• Outcome bias: The tendency to judge a decision by its outcome rather than by the quality of the decision at the time it was made

• Recency bias: The tendency to weigh recent data or experience more than earlier data or experience

• Anchoring: The tendency to rely too heavily, or anchor, on readily available information

• Bandwagon effect: The tendency to believe things because many other people believe them

• Belief in the law of small numbers: The tendency to draw unjustified conclusions from too little information.

Although this list is not comprehensive, it includes some of the most powerful misperceptions that affect trading and prices.

In another edition of this newsletter, we'll look at each cognitive bias in greater detail.
TAMING THE TURTLE MIND

Part Two

by Curtis Faith

Excerpted from the Newly Released Way of the Turtle

In part of this excerpt from the excellent new book by Curtis Faith, we detailed some of the most powerful misperceptions that affect trading and prices. If you missed part one, click here.

This week we'll look at each cognitive bias in greater detail.

People who are affected by loss aversion have an absolute preference for avoiding losses rather than acquiring gains. For most people, losing $100 is not the same as not winning $100. However, from a rational point of view the two things are the same: They both represent a net negative change of $100. Research has suggested that losses can have as much as twice the psychological power of gains. In terms of trading, loss aversion affects one’s ability to follow mechanical trading systems because the losses incurred in following a system are felt more strongly than are the potential winnings from using that system. People feel the pain of losing much more strongly when they follow rules than they do when they incur the same losses from a missed opportunity or by ignoring the rules of the system. Thus, a $10,000 loss is felt as strongly as a $20,000 missed opportunity. In business, sunk costs are costs that already have been incurred and cannot be recovered. For example, an investment that already has been spent on research for a new technology is a sunk cost. The sunk cost effect is the tendency for people to consider the amount of money that already has been spent—the sunk costs—when making decisions.

Say the ACME Company has spent $100 million developing a particular technology for building laptop displays. Now suppose that after spending this money it becomes obvious that an alternative technology is much better and more likely to produce the desired results in the required time frame. A purely rational approach would be to weigh the future costs of adopting the new technology against the future expense of continuing to use the developed technology and then make a decision solely on the basis of future benefits and expenditures, completely disregarding the amount of money that already has been spent.

However, the sunk cost effect causes those who make this decision to consider the amount of money previously spent and view it as a waste of $100 million if a different technology is used. They may choose to continue with the original decision even if it means spending two or three times as much in the future to build the laptop displays. The sunk cost effect leads to bad decision making that often is heightened in group situations.

How does this phenomenon influence trading? Consider the typical new trader who initiated a trade with the expectation of winning $2,000. At the time the trade first was entered, he decided that he would exit the position if the price dropped to the point where a $1,000 loss would be incurred. After a few days, the trade’s position is at a $500 loss. A few more days pass and the loss grows to over $1,000: More than 10 percent of the trading account. The value of that account has dropped from $10,000 to less than $9,000.

This also happens to be the point where the trader previously decided to exit.

Consider how cognitive biases might affect the decision whether to keep true to the prior commitment to get out at a $1,000 loss or to keep holding the position. Loss aversion makes it extremely painful for the trader to consider exiting the position because that would make the loss permanent. As long as he does not exit, he believes there is a chance that the market will come back and turn the loss into a win. The sunk cost effect makes the decision not one of deciding what the market is likely to do in the future but one of finding ways to avoid wasting the $1,000 that already has been spent on the trade. So, the new trader continues to hold the position not because of what he believes the market is likely to do but because he does not want to take a loss and waste that $1,000. What will he do when the price drops even more and the loss increases to $2,000? Rational thought dictates that he will exit. Regardless of his earlier assumption about the market, the market clearly is telling him that he was wrong, since it is far past the point at which he originally decided to exit. Unfortunately, both biases are even stronger at this point. The loss he wishes to avoid is now larger and even more painful to consider. For many, this kind of behavior will continue until the trader loses all his money or finally panics and exits with a loss of 30 to 50 percent of his account, perhaps three to five times what he had planned

worked in Silicon Valley during the height of the Internet craze and had many friends who were engineers and marketers for hightech companies. Several of them were worth millions from stock options on companies that recently had gone public. They watched the prices go up day after day during late 1999 and early 2000. As prices started to drop in 2000, I asked many of them when they were going to sell their stock. The reply was inevitably something along the lines of the following: “I’ll sell if it gets back up to $X,” a price that was significantly higher than the level at which the market was when I asked. Almost every single one of my friends who was in this position watched the price of his or her stock drop to a tenth or even a hundredth of its previous value without selling the shares. The lower it dropped, the easier it was for them to justify waiting. “Well I’ve already lost $2 million. What’s a few more hundred thousand?” they would say.

The disposition effect is the tendency for investors to sell shares whose price is increasing and keep shares that have dropped in value. Some say that this effect is related to the sunk cost effect since both provide evidence of people not wanting to face the reality of a prior decision that has not worked out. Similarly, the tendency to lock in winning trades stems from the desire to avoid losing the winnings. For traders who exhibit this tendency, it becomes very difficult to make up for large losses when winning trades are prematurely cut short of their potential.

Outcome bias is the propensity to judge a decision by its outcome rather than by the quality of the decision at the time it was made. Much of life is uncertain. There are no right answers to many of the questions that involve risk and uncertainty. For this reason, a person sometimes will make a decision that he considers rational and that appears to be correct, but as a result of unforeseen and unforeseeable circumstances that decision will not lead to the desired outcome. Outcome bias causes people to put too much emphasis on what actually occurred rather than on the quality of the decision itself.

In trading, even a correct approach can result in losing trades, perhaps a few in a row. These losses can cause traders to doubt themselves and their decision process, and they then evaluate the approach they have been using negatively because the outcome of that approach has been negative. The next bias makes this problem particularly acute.

Recency bias is the tendency for individuals to place greater importance on more recent data and experience. A trade that was made yesterday weighs more heavily than do trades from last week or last year. Two months of losing trades can count as much as or more than the six months of winning trades that happened previously. Thus, the outcome of a series of recent trades will cause most traders to doubt their method and decision-making process. Anchoring is the tendency for people to rely too heavily on readily available information when making a decision involving uncertainty. They may anchor a recent price and make decisions on the basis of how the current price relates to that price. This is one of the reasons my friends had such difficulty selling their stocks: They were anchoring on the recent highs and comparing the current price with those highs. After they made that comparison, the current price always looked too low.

The observation that people often believe things because many other people believe them is known as the bandwagon effect or the herd effect. The bandwagon effect is partially responsible for the seemingly unstoppable increase in prices at the end of a price bubble.

People who fall under the spell of the law of small numbers believe that a small sample closely resembles the population from which it is drawn. The term is taken from the statistical law of large numbers, which shows that a large sample drawn from a population does closely resemble the population from which it is taken.

This law is the basis of all polling. A sample of 500 taken randomly from a larger population can give very good estimations for a population of 200 million or more people. In contrast, very small samples do not reveal much about the underlying population. For example, if a trading strategy works four times out of a test of six times, most people would say the strategy is a good one, whereas statistical evidence indicates that there is not enough information to draw that conclusion with any certainty. If a mutual fund manager outperforms the indexes three years in a row, he is considered a hero. Unfortunately, a few years of performance says very little about what the long-term expectations might be. Belief in the law of small numbers causes people to gain and lose too much confidence too quickly. When combined with the recency effect and outcome bias, it often results in traders abandoning valid approaches just before those approaches start working again. Cognitive biases have a profound effect on traders because if a trader is not influenced by them, almost every bias creates opportunities to make money. In the following chapters, as specific aspects of the Turtle Way are explored, you will see how avoiding these biases can provide you with a significant advantage in trading.

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