Trading: It s completely mental

Transcription

1 Trading: It s completely mental An introduction to Behavioural Finance

2 Cognitive Biases not Mental Health Issues Gambler s Fallacy not Gambling Addiction!

3 Thinking, Fast and Slow Daniel Kahneman

4 Two Systems System 1: Fast, automatic, frequent, emotional, stereotypic, unconscious. see that an object is at a greater distance than another localize the source of a specific sound complete the phrase "war and..." display disgust when seeing a gruesome image solve 2+2=? System 2: Slow, effortful, infrequent, logical, calculating, conscious. brace yourself before the start of a sprint sustain a higher than normal walking rate determine the appropriateness of a behavior in a social setting count the number of A's in a certain text determine the price/quality ratio of two washing machines determine the validity of a complex logical reasoning solve 17*14

5 Substitution When faced with a complex problem, we are reluctant to engage System 2; we much prefer to leave it to System 1. Faced with a difficult problem, we frequently resort to answering a different, much simpler question. An easy question (How do I feel about it?) is substituted for a difficult one (what do I think about it?). Kahneman labels the real question the target question and the lazy question the heuristic question Target question This candidate is running for election? How far will he go in politics? Heuristic question Does this candidate look like a winner?

6 Substitution Kahneman suggests, a lazy System 2 often follows the path of least effort and endorses a heuristic answer without much scrutiny of whether it is truly appropriate. You will not be stumped, you will not have to work very hard, and you may not even notice that you did not answer the question you were asked. Furthermore, you may not realise that the target question was difficult, because an intuitive answer came readily to mind.

7 Question If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? [ minutes ]

8 Question A bat and a ball together cost 110 cents. The bat costs 100 cents more than the ball. How much does the ball cost? [ cents ]

9 Question In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake? [ days ]

10 Question What is the next number in the series? 3, 6, 12, 24,.,..,..,

11 Cognitive Biases Introduction

12 Cognitive Biases Cognitive bias describes the inherent thinking errors that humans make in processing information. These thinking errors prevent us from accurately understanding reality, even when confronted with all the needed data and evidence to form an accurate view.

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14 Too Little Time Too much information What should we remember Not enough meaning Our brains need to skim and filter vast amounts of information and quickly, almost effortlessly, decide which few things are actually important. Our brains need to remember the most important and useful bits of new information. We need to fill in the gaps, and map it all to our existing mental models. In the meantime, we also need to make sure that it all stays relatively stable and as accurate as possible. Our brains need to make splitsecond decisions that could impact our chances for survival, security, or success.

15 4 Main Messages We don t see everything. Some information we filter out is actually useful and important. Our search for meaning can involve filling in gaps with untruths. We sometimes imagine details that were filled in by our assumptions, and construct meaning and stories that aren t really there. Quick decisions can be seriously flawed. Some decisions we jump to are unfair, self-serving, and counter-productive. Our memory reinforces errors. Some information we remember for later exacerbates the biases.

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18 Overall Theme Risk Management A second pair of eyes Planning Keep records. Don t rely on memory - Trading Plans Which is why institutions do better than retail investors typically. It is the systems and processes within Institutions that protect against an individual s individuals biases. Options Risky? Really!

19 The Paradox The Problem Cognitive Biases are so diverse and complicated that there is a tendency towards information overload, leading to a desire to simplify things by filtering them which is the basis of a number of cognitive biases. Real life situations do not fall into simple discrete definitions. At any one time, a number of cognitive biases could be in play. They are often demonstrated by simple neat experiments, but real life tends to be more complicated.

20 Cognitive Biases in yourself Identify those you are most prone to and protect Cognitive Biases: The best you can hope for Cognitive Biases in others??

21 Cognitive Biases: Industries and Professions Politics Religion Advertising and Sales Professions Financial Industry Medical Profession Legal Profession Judges and Juries

22 Cognitive Biases Introduction

23 Bias blind spot PreTrade Manage Trade Post Trade The Bandwagon Effect Confirmation Bias Profit Close Trade too early Risk Averse Manage Trade / Maintain Stop Loss Pyramiding Take Excessive Risks / Hold profitable trades too long Endowment Effect Mental Accounting (House s money) Hindsight Bias Survivorship Bias Anchoring Bias Framing Effect Anchoring Bias Status Quo Bias I am a genius Enter Trade (Long) Breakeven Disposition Effect Self-Attribution Bias Availability heuristic Pareidolia Gambler's fallacy / Clustering illusion Dunning Kruger effect Loss Do Nothing / Move Stop Loss Down Status Quo Bias Post-Purchase Rationalisation Conservatism (belief revision) Maintain Stop Loss Illusion of control Double (Average Cost) Down Sunk-Cost Fallacy Optimism bias Risk Seeking Overconfidence effect Its other peoples fault Lack of Confidence Confidence Overconfidence

24 Overconfidence 1. They found that the share of people with the very highest level of intelligence ( level 9 ) was twice as high in computing and in the combined professions of law, consulting and accounting as in finance. 2. They found that the proportion of people with some of the highest levels of intelligence (levels 7 and 8) who work in finance fell between 1990 and 2014, while the proportion of people with intelligence level five increased in the industry, particularly between 1995 and The Swedish researchers findings echo those of a Harvard University study of MIT students in 2016, which found that the top students were avoiding finance, and that the industry was instead more likely to attract MIT students from the lower academic quartiles in other words academically average frat boys.

25 Overconfidence Confidence implies realistically trusting in one's abilities, while overconfidence usually implies an overly optimistic assessment of one's knowledge or control over a situation. In a 2006 study entitled "Behaving Badly", researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered aboveaverage job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey group believed that their job performance was average or better. Overconfident Investing In a 1998 study entitled "Volume, Volatility, Price, and Profit When All Traders Are Above Average", researcher Terrence Odean found that overconfident investors generally conduct more trades than their less-confident counterparts. Odean found that overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to enter/exit a position. Unfortunately, Odean also found that traders that conducted the most trades tended, on average, to receive significantly lower yields than the market.

26 Loss Aversion: Cartoon Loss Aversion - The disutility of giving up (losing) an object is greater than the utility associated with acquiring (gaining) it. We don t want to be losers. We would rather win less than to lose. Enter Move stop loss to breakeven and getting taken out in normal price movements Stop-loss

27 Loss-Aversion vs Risk Aversion: Disposition Effect Loss aversion, differs from risk aversion, is where people express both risk aversion and risk seeking behaviour. Loss aversion is not just the desire to reduce risk; it is an utter contempt for loss. Individuals who are loss averse feel the sting of loss twice as great as the joy from an equal size gain and make investment decisions accordingly. Loss averse investors are quick to lock in investment gains (risk averse), and hold on to their losing positions (risk seeking). Research shows investors are 1.7 times more likely to sell a winning stock than a losing stock Investors are influenced by pride and fear to sell current winning positions, and to hold on to losers. They can feel good in knowing they realized a gain, and ride the losing positions so not to have to realize the loss.

28 Anchoring Effect: Cartoon Anchoring effect the tendency to rely too heavily, or "anchor," on a past reference or on one trait or piece of information when making decisions (also called "insufficient adjustment").

29 Anchoring Bias RRP Upsize In finance Former highs and lows can act as Anchors Price targets stick. Broker s recommendations Your past history with the instrument Entry, Exit levels The market has a memory

30 Survivorship Bias Researchers from the Center for Naval Analyses had conducted a study of the damage done to aircraft that had returned from missions, and had recommended that armor be added to the areas that showed the most damage.

31 Survivorship Bias Statistician Abraham Wald noted that the study only considered the aircraft that had survived their missions the bombers that had been shot down were not present for the damage assessment. The holes in the returning aircraft, then, represented areas where a bomber could take damage and still return home safely. Wald proposed that the Navy instead reinforce the areas where the returning aircraft were unscathed, since those were the areas that, if hit, would cause the plane to be lost. Trading A commentator will gain infamy esteem for his / her correct predictions. How many were incorrect? You extrapolate your wins into an annual return You tell people about your winners, what about your losers?

32 Confirmation Bias: The tendency to search for, interpret, focus on and remember information in a way that confirms one's preconceptions. Confirmation Bias: Cartoon

33 Confirmation Bias We do not like people or information that contradicts our thoughts. We like them when they confirm what we think. Hence, we tend to place more weight on information that confirms our position. This cognitive bias is insidious. As we give more weight to things that confirm our thoughts, we become more confident. As a result, we become less aware of the fact that we are affected by confirmation bias. This bias leads to a vicious cycle that ends in self-deception. Trading Examples Looking for news, patterns and indicators to support our current investment position? Practical Tips In practice, look for reasons against taking a trade and not for it. When in doubt, ask yourself what kind of market development or price action might negate your view? If you cannot answer this question, you are affected by confirmation bias.

34 Endowment Effect The endowment effect is a hypothesis that people value a good higher once they own it. In other words, people place a higher value on objects they own relative to objects they do not. It is inconsistent with standard economic theory which asserts that a person's willingness to pay (WTP) for a good should be equal to their willingness to accept (WTA) compensation to be deprived of the good. You own shares You are not willing to sell them. Why? Because you think they are worth more. So then you should buy more. No, because you think they are fairly (over valued). Changing your price targets. Not being content with what you have diminishing marginal returns

35 Availability heuristic assigning higher probabilities to what is more available in our memory, which is biased toward vivid, unusual, or emotionally charged examples. Availability Heuristic: Cartoon

36 Availability Heuristic People fear flying more than they do driving a car Participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. It also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.

37 Hindsight Bias: Cartoon Hindsight bias - sometimes called the "I-knew-it-all-along" effect, the tendency to see past events as being predictable at the time those events happened. (sometimes phrased as "Hindsight is 20/20").

38 Hindsight Bias Yes, I knew it all along. Trading Examples Presenters looking at a Historical Chart and deciding where you would have taken trades Investment gurus showing you their successful trades in the past

39 Post-Purchase Rationalisation Post-Purchase Rationalisation: The tendency to persuade oneself through rational argument that a purchase was good value. A trader s most common purchase is getting into a trade position in the market. Trading Examples Justifying your trade through whatever means. See Confirmation Bias

40 Attribution Bias When things go well, it is because of me. When things go south, it is definitely not my fault. Trading Examples After a winning trade, you start to feel like a genius, thinking that your trading skills made it possible. After a losing trade, you blame your broker, your computer, and your cat. Practical Tips Take credit for the right things. Take credit for following your rules, and not for your profitable trades. Take credit for your consistent profits over a large sample, and not for a single profitable trade. Assume responsibility for everything, including your losses. Taking responsibility to find out what went wrong and doing what is needed to improve.

41 Bias Blind Spot You see that other people are biased, but do not realise your own cognitive biases. To find your own cognitive biases, get someone else s opinions. We all have blind spots when we look at ourselves.

42 Awareness of Cognitive Biases Helps Once we are aware of these cognitive biases, we stand a better chance at overcoming them in our trading. Cognitive biases manifest in many ways, both in our life and trading behaviour. To deal with them effectively, we must be mindful of these biases in our daily life as well. (See Daniel Kahneman s Thinking, Fast and Slow.) It is not a trader s job to learn how to label cognitive biases. Our job is to ground our decisions in solid and consistent analysis, reducing the effect of one bias at a time. It is futile to try and eliminate our own cognitive biases completely. Recognition of out our CB is the first essential step.

43 Framing effect - drawing different conclusions from the same information, depending on how that information is presented. Framing Effect: Cartoon

44 Mental Accounting The tendency for people to separate their money into separate accounts in their mind, as a minimum, based on a variety of subjective criteria, like the source of the money and intent for each account. According to the theory, individuals treat each account differently, which has an often irrational and detrimental effect on their consumption decisions and other behaviours. Although many people use mental accounting, they may not realize how illogical this line of thinking really is. For example, people often have a special "money jar" or fund set aside for a vacation or a new home, while still carrying substantial credit card debt. Christmas Club accounts Gambling with the House s money Trading with winnings

45 Sunk Cost Fallacy: Cartoon The phenomenon where people justify increased investment in a decision, based on the cumulative prior investment, despite new evidence suggesting that the decision was probably wrong. Also known as the Irrational escalation.

46 Gambler s fallacy - the tendency to think that future probabilities are altered by past events, when in reality they are unchanged. Gambler s fallacy: Cartoon

47 Dunning-Kruger Effect: Cartoon Dunning-Kruger effect - a twofold bias. On one hand the lack of metacognitive ability (cognitive self-awareness) deludes people, who overrate their capabilities. On the other hand, skilled people underrate their abilities, as they assume the others have a similar understanding.

48 Creating the target after the shots have been fired. Texas Sharpshooter: Cartoon

49 Options as an alternative

50 Options Myths Options are risky You can lose all of your money with options Most options expire worthless

51 Thank you