Tuesday, December 26, 2006

Three Pervasive Myths of Trading Psychology

My work as a trading psychologist has provided me with a fascinating window on the factors that separate successful from unsuccessful traders across a variety of settings, from proprietary firms to investment banks to hedge funds. Having met and worked personally with well over 100 professional traders in the past few years, the main conclusion I’ve come to is that most of the generalizations about trading success are simply not true. In this article, I thought I’d summarize three of the more pervasive myths about trading success out there and offer my own, different perspectives.

Myth #1: Emotions are at the root of trading problems. Yes, emotions can interfere with concentration and performance, but that doesn’t mean that they are a primary cause. Indeed, emotional distress is as often the result of poor trading as the cause. When traders fail to manage risk properly, trading size that is too large for their accounts, they invite outsized emotional responses to their swings in P/L. Similarly, when traders trade untested patterns that possess no objective edge in the marketplace, they are going to lose money over time and experience an understandable degree of emotional frustration. I know many successful traders who are fiercely competitive and highly emotional. I also know many successful traders who are highly analytical and not at all emotional. Trading is a performance field, no less than athletics or the performing arts. Success is a function of talents (inborn abilities) and skills (acquired competencies). No amount of emotional self-control can turn a person into a successful musician, football player, or trader. Once individuals possess the requisite talents and skills for success, however, then psychological factors become important. Psychology dictates how consistent you are with the skills and talents you have; it cannot replace those skills and talents.

Myth #2: Anyone, with dedicated effort, can get to the point of trading for a living. That is nonsense. How many people make their living from acting or musical performance? What proportion of people playing sports can actually make their livelihood from athletics? Many people play chess or poker, but how many can sustain a living from it? Quite simply, to make a living from any performance activity means that you are consistently good at what you do. Not everyone has the talent, skill, or drive to be that successful—in any field. Across the many traders I’ve met in various settings, from home-based, independent traders to professional ones in firms, the best predictors of trading success have been the size of the trader’s account and the resources available to the trader. If a person were to make 30% per year on their accounts year after year, they would be among the world’s most successful money managers. Most money managers of mutual funds, hedge funds, and pension funds cannot sustain such performance. If, however, a trader begins with $60,000 of capital, he or she may not be content with $18,000 of profit. This leads the trader to accept huge leverage and court a risk of ruin when an inevitable string of losing trades occurs. Indeed, such excess leverage is a main cause of emotional distress in trading. Take a look at how the Turtles made their money: they learned a trading method, learned to be consistent with that method, and were given enough money by Richard Dennis that they could trade multiple markets with enough size to scale into positions in each. Even with those resources, not all of the Turtle students could succeed. Talent, skill, and opportunity are the ingredients of success, and these are relatively normally distributed in the trading population, just as they are relatively normally distributed in the population at large.

Myth #3: The main cause of trading failure is a loss of discipline. This is a myth perpetuated by “trading coach” and “guru” types that: a) don’t trade themselves and b) have a vested interest in your belief that their services are all that stand between you and success. The main cause of trading failure is a lack of an objective edge in the marketplace, trading random patterns that have never been tested out for success. We would never consider buying a car simply by looking at it. We’d want to research it, test-drive it, and peer under the hood. Amazingly, however, many traders will risk far more money trading patterns that they never research or test-drive. Many times, the reason they stray from those methods is that, intuitively, they realize that those methods are not working. In any performance field, we find a hard-and-fast truth: the great performers spend more time practicing their performances than actually performing. That is just as true for the Broadway actress as for the Olympic athlete. Many traders, however, think that on-the-job training will be enough. Unfortunately, their accounts often don’t survive their learning curves. A well-placed executive within a trading firm confided to me last year that the average time it takes the average trader to blow through their entire account is seven months. That is why brokerage firms are always on the hunt for new customers. It’s not that these traders are all deficient in discipline: they simply haven’t engaged in sufficient practice to figure out the right markets and trading styles for them and to hone their skills. In every other performance field, you can find relatively easy levels of competition: you can join a community theater, play rounds of golf at the par-3 course, or set the challenge level on your chess computer. There is no easy level of competition in trading, however. When you place a trade on a major exchange, you are up against the pros from day one. No wonder it is so difficult to succeed! Discipline is necessary for trading success, but there is much more to success than discipline. It takes concerted practice and the cultivation of skills at reading and acting upon market patterns.

In an ideal world, I wouldn’t have to challenge these myths. You’d be able to obtain very realistic messages about trading success from brokerage firms, vendors, trading gurus, books, and magazines. The reality, however, is that most of these commercial entities have a vested interest in perpetuating a dream that is, in reality, a cruel fantasy: that, without real, sustained effort, anyone can make it big as a trader.

Does that make me a Scrooge during this holiday season, saying “Bah, humbug!” to the aspirations of thousands of traders? I think not. The reason I wrote my most recent book, Enhancing Trader Performance, was to show that there is a common process beneath the development of elite performance in any field. That process involves several components:

Finding a Niche – Identifying a performance field that takes maximum advantage of your skills, talents, and interests;

Deliberative Practice – Rehearsing skills in increasingly realistic settings to prepare for the challenges of actual performance;

Constant Feedback – Intensive review of performance to identify strengths and weaknesses, so that you can capitalize on the former and address the latter.

The successful traders I’ve known have found a market (or set of markets) and a trading style that capitalizes on their abilities. They have been relentless in working on their skills, using videotaping to review markets and performance and using simulators to rehearse under different market conditions. To sustain such effort requires a love of the markets themselves, something not all traders have. Some traders love the action, some love the dream of making money, some love the opportunity to work for themselves—but many don’t love the work itself: the effort of mastering patterns in demand and supply.

Success is possible in trading as it is in any performance field. If anyone tells you, however, that the path to trading success is different than it is for the surgeon or Olympian, you know that you’re hearing a myth. If you choose the path of the elite performer, trading can be wonderfully challenging and rewarding. If trading is not your ideal path for self-development, however, you are far better off finding your passion elsewhere and managing your money prudently. The goal is to develop the best within you, whether that is as a trader or as something else. Your life deserves nothing less.


wincity said...

Great article, Dr. Brett. I've seen lots of people trading random setups and then blame the market for being choppy or for lacking opportunities. The important thing, as you pointed out, is the edge which requires lots of time and trouble to develop.

yinTrader said...

Hi Brett

Myths have a way of perpetuating and it may take an unreasonable man to offer his own perpectives.

Quote - George Bernard Shaw
The reasonable man adapts himself to the conditions that surround him.The unreasonable man adapts surrounding conditions to himself. All progress depends on the unreasonable man. Unquote

Your quote:
..there is a common process beneath the development of elite performance in any field. Unquote

No easy way out, to become good at any career, for sure.

Brett Steenbarger, Ph.D. said...

Thanks, Wincity; I think you're right. It's hard to have confidence in your trading if you don't really *know* that you have an edge.


Brett Steenbarger, Ph.D. said...

Hi Yin,

Great Shaw quote. The really good traders adapt their trading to their own interests and strengths. Thanks for the comment--


b hong said...

Thanks for the great article. As a physician, I've got my own healthy amount of skepticism about the exorbitant claims of success by these trader's coaches. You and I both know how hard it can be to help people turn their lives around.

One trader's coach told of her success with a multi-millionair who lost $75,000 in one day. She said that she "cured" him in only one session!

When I heard that story, i was outraged that she was claiming him as one of her successes. If he was, indeed, a multimillionair, he didn't NEED to trade for a living and only needed someone to tell him to stop feeling sorry for himself.
As P.T. Barnum said: There's a sucker born every minute." Thanks for helping us keep a level head and to keep everything in perspective.
Bruce Hong, MD

Michele said...

Very nice points. I wonder where these myths come from. For example, no one ever says "Anyone, with dedicated effort, can become a brain surgeon". I think it's because trading is an *anti-virtuosic* activity. Pianists are familiar with the concept of virtuosic pieces, those that sound harder than they actually are to play. Similarly, anti-virtuosic pieces are harder in fact than they sound (pianists hate these).

Trading, at first glance, seems trivially simple. "Buy low sell high". Done. There's a disingenuous and seductive ad running on CNBC for a broker with a chart and "BUY" printed at all the lows, and "SELL" on all the highs. People just don't realize the difficulty of the problem. It just doesn't *seem* very hard.

Even having done this full time for over a year, I'm still learning what I don't know.

Brett Steenbarger, Ph.D. said...

Hi Bruce,

Thanks for your note. You raise a very legitimate point, and it's probably one I should address: how long does it typically take for people to make lasting changes in their behavior? It turns out in the research literature that it's much easier to initiate changes than to sustain them!


Brett Steenbarger, Ph.D. said...

Hi Michele,

I like that analogy with "virtuosic" music. You hit the nail exactly: people see a person recognizing patterns and profiting from them and think, "If he can do it, why can't I?" Of course, they don't say the same thing when they see Tiger Woods or Garry Kasparov compete.

I've had the good fortune to actually watch successful traders trade *as they are trading*. That enables me to see what they see and hear what they're thinking. I could no more replicate their trades than I could duplicate a ballet dancer after careful observation. These traders have unusual gifts that are not well appreciated or understood.


davidino said...

This article is absolutely one of the best I ever read about trading.

Thanks a lot Doctor.

b hong said...

Ha Ha
A very 'a propos' statement, considering that New Year's resolutions are coming up!

Anonymous said...

"There's a disingenuous and seductive ad running on CNBC for a broker with a chart and "BUY" printed at all the lows, and "SELL" on all the highs. People just don't realize the difficulty of the problem. It just doesn't *seem* very hard."

Let face it, CNBC is purely entertainment, not news or thoughtful insight. Most of the guests are promoting their "edge" which basically involves you sending them your money.


Brett Steenbarger, Ph.D. said...

Thanks, Davidino; I appreciate the feedback--


Brett Steenbarger, Ph.D. said...

Hi Bruce,

We'd all be rich if we could short people's (and our own!) New Year's resolutions!


Brett Steenbarger, Ph.D. said...

Hi Marc,

I think CNBC has a difficult task: walking the line between news and entertainment. Having been interviewed by CNBC and having met a couple of their anchors, my impression is that they're doing a serious job of trying to bridge that gap. The hard part for the interviewees is trying to fit complex answers and issues into small sound bites. Inevitably, you come off sounding like an idiot!

Along the lines of your comment, though, I would like to see more investigative reporting on CNBC--and I think there might be an audience for that. Thanks for your comment--


Anonymous said...

This is a superb blog entry Dr. Steenbarger, and I wish you would focus more on the psychology of trading and less on backtesting. I just ordered your _Enhancing Trader Performance_ from Amazon, and looking forward to reading it.

I can only attest to my own experiences, but what you are saying does correspond with them. I've been trading for a living for maybe 5 years. Looking back on the first few, it's amazing how naive I was. However, it's also worth looking back and paying attention to what worked even then. I had some big winners that have formed the core of what I deem to be my edge.

If, however, a trader begins with $60,000 of capital, he or she may not be content with $18,000 of profit.

I started similarly capitalized, and luckily I live lean and am young enough not to have too many financial committments. I was content with $18k of profit, and I have been able to build up my capital stock while building up my skills and knowledge of how I behave in the markets, not to mention how the markets behave regardless of me.

This gets to something of a myth that I've developed. I say backtesting is overrated, it's front-testing that matters. It's the hard right edge that all traders have to contend with. I'm sure you disagree with me about backtesting. But I look at it this way. My time is limited, and my interest in developing models of trading is roughly nill. However, I am passionate about other areas of the market. I devoted my time to learning tape reading, and how to read financial statements, and developed a further understanding of economics. I think that this was all energy and time well spent. I spent years watching every little tick of the market, to the point that I now have an almost intuitive understanding of what's going on. This is something you probably find in a lot of floor traders.

My educational background is in sociology and anthropology. I am far more interested in the fact that the stock market is composed of human participants who in aggregate often behave in rather predictable ways than I am in developing countless systems that need to be tested against old data. I have operated under the assumption that I am the system, and the more I can perfect my understanding of the data available today, from the macro to the micro, the better I will be at reacting to change.

I feel like this may have been my breakout year. I finally started with enough skin in the game that outsized returns now do make a difference. I'm pushing somewhere close to 60% market gains for '06. I've developed new techniques and styles that I believe will suit me well in the coming year, like short selling. I've improved my understanding of options trading. Funny thing is that when I look at all the mistakes I've made this year, I'm amazed that I was able to produce such big returns. The goal for '07 is to reduce the mistakes, and trade less but trade smarter. Thanks for the blog Doc.

Brett Steenbarger, Ph.D. said...

Thanks, MomoFader. I actually agree with much of what you say re: backtesting/systems, which is why I'm not a mechanical trader. On the other hand, if there is a directional tendency in the market, I have two choices: to trade with knowledge of it or to trade in ignorance of it.

My view is that historical patterns *are* part of trading psychology. When you read buying in the order flow *and* you know there's a solid historical tendency toward strength, you can enter the market with confidence. I've known too many intuitive traders who become very sensitive to market patterns, only to become disoriented when those patterns change. The historical testing is one way I stay oriented and alert for those changes.

Congratulations on your success in 2006 and best wishes for a happy and prosperous '07!


Brandon Wilhite said...

Dr. Brett,

I do almost all of my backtesting by hand. Why? Well at first it was becaue I was cheap (I've paid before for expensive backtesting software), but eventually I also realized that I was much more comfortable with my results this way. By this point I've also played through the past of my primary markets many many times on many timeframes. I also watch them real-time pretty closely. I think that this probably provides me with a similar benefit to that achieved by recording the market's daily action and then re-playing it. I'm currently working on obtaining/implementing the technology to do that too.


Brett Steenbarger, Ph.D. said...

Hi Brandon,

I also find that doing the historical pattern analysis by hand keeps me grounded in the market data and helps me be more sensitive to patterns--and shifts in patterns--over time. Thanks for the comment--


Muaad said...

Dr. Brett,

I have learned much from your work and thank you for that.

Very interesting article you have written here, but I must say I disagree with some of the points you have made.

Having a statiscally reliable, scientifically proven edge is very crucial in the markets, but I do not believe it is the determining factor for a professional trader. Even if one possessed an edge that provided a better return than 90% of professional traders and hedge funds, he would not succeed in maintaining consistent profitability if he did not have the right beliefs and a sound understanding of the markets. I believe this is the key defining factor between a successful and a struggling trader.

Successful traders simply think differently. They understand that the markets simply operate in probabilities, and whatever variables they use to define an edge... even if they be 90% accurate... still have the possibility of failure; and so they always accept the risk and are not in a state of conflict when executing stop losses, nor do they block out information and get bogged down by plenty of other psychological games because they have learned that the market is always right.

So even if you have a proven edge, if you do not have a sound understanding of the nature of the markets then you will still fall victim to many errors which will effectively nullify long-term, consistent success.

At the same time, if you do have a sound understanding and the correct beliefs about the market and proper money management but do not have a proven edge... you will definately fail, because without the edge, you will simply experience random, haphazard profits and losses.

So I see successful trading, as Dr. Alexander put it, as being composed of three key aspects: 1. Mind, 2. Method, 3. Money Management.

All three of these are necessary and crucial to trading success, but the Mind aspect is by far the most crucial, for it is the foundation of understanding the markets, and will work to immediately dispel the internal conflict traders may have to go through, thereby allowing them to maintain objectivity.

The Method has to do with using your analysis to successfully attain a proven edge - which without you cannot win.

Lastly, the Money Management answers the "How Much?", for even with an edge, if you bet too much you will still run the risk of ruin before the probability works itself in your favor.

Once again, even with proper Money Management *alone* one cannot succeed without the proven edge. So these three aspects are to be taken as a whole, each complementing the other, with the Mind aspect encompassing the other two. If you have the right understanding of the markets then you will understand the nature of probabilities and the need for a statiscially reliable edge and proper risk control.

As far as succeeding in trading for a living or trading professionaly, I firmly believe that if a man has a passion for something, develops the talent and skills needed, and truly believes he can do it, then he will do everything in his power to work towards this goal and achieve that.

One of my favorite quotes is that of Confucius:

"The man who thinks he can; the man who he thinks he cannot... They are both right."

I hope I have articulated myself enough here.

Kind Regards,

Brett Steenbarger, Ph.D. said...

Thanks for your comments, Muaad. You mention that "As far as succeeding in trading for a living or trading professionaly, I firmly believe that if a man has a passion for something, develops the talent and skills needed, and truly believes he can do it, then he will do everything in his power to work towards this goal and achieve that." I agree with you: the mindset of a winner must accompany the skills and talents. Indeed, without that mindset there will not be the kind of intensive deliberative practice that builds skills over a period of years.

My point, which I'm grateful for the opportunity to clarify, is that a "passionate" mindset cannot *substitute* for those skills and talents. I could be passionate about succeeding as an athlete or as a musician, but if I do not possess requisite talents, I will be a passionate mediocrity, not an elite performer.

It's where the driving, competitive mindset is yoked to inborn abilities (talents) that we see a process of development that results in skills. The three, indeed, are interwoven.

Thanks for the thoughtful observations--


Anonymous said...

Hello Brett,

Thanks for the great article, can you describe more what are these of 'inborn talents'? Can one develop such talents? Or some people simply don't have them?

Brett Steenbarger, Ph.D. said...

Hi MagickMystik,

I'm following convention by referring to skills as acquired competencies and talents as inborn abilities. Examples of talents would be artistic, athletic, or mathematical ability that show up very early in life. It is certainly possible to develop skills in these areas even when lacking a high degree of inborn talent, but the research tells us that very high levels of performance occur when skills build upon talents. Among traders, talents include analytical ability, speed of mental processing, and capacity of working memory. Thanks for the excellent question and the opportunity to clarify--


MY JOURNEY said...

Dear Brett

Thanks. Your thoughts are of great help.