Tuesday, April 17, 2007

The Most Dangerous Word in the Trader's Vocabulary

I'm convinced the most dangerous word in the trader's vocabulary is "should". Should can turn a winning day into a psychological loser, when a trader focuses on that move he or she should have traded. Should can make us miserable when we don't live up to our personal or financial expectations. Sometimes we focus so much on how we should trade or on how others tell us we should trade that we drift away from our own talents and interests.

But those sabotages are nothing compared to getting locked into views of how the market should be trading:

* The dollar is plunging, so we should get inflation and the market should drop!

* The market is in an uptrend, so we should rally today!

* We're in a growing deficit as a country; we're mired in Iraq; oil prices are skyrocketing, so we should have a bear market!

I can tell you this: I became a better trader when I started focusing on what the majority of stocks were doing rather than on what I thought the market should do.

On Monday, I thought we should get a higher market on Tuesday. When I saw that fewer stocks were making new highs in the morning even as the ES was moving to new price highs, however, I dropped the should and sold the open.

And, yes, I--like so many participants in the financial markets--lament the high debt, weak dollar, and rising commodity prices. But we have recovered from a steep decline, dollar flows into stocks are above average, and--as of Monday--well over 2000 stocks had made fresh 20-day highs. No matter how much I think the market should go down, it's not what the market data have been telling us.

"Should" puts my judgment ahead of the market's objective reality. And that's why it's the most dangerous word in the trader's vocabulary.


bhong said...

"We have met the enemy, and he is us" Pogo/Walt Kelly

For years I have been using the concept of "The Tyrrany of the Shoulds" to explain the willingness of others to tell me/us/the country/the world how we "should" think, believe, speak, act, etc. Interestingly - it's always the way THEY think and act!

Now, you expose another Fatal Flaw. Our own self-dialogue. Is there no end to this tyrrany?!

Seriously, I think that too many people focus on the role of "emotion" in their poor decision-making. If we have certain expectations of outcome, and they don't come to pass, then we can respond emotionally. When we say 'should result in...' that biases us. When that outcome does not come to pass, we can respond with anger, hurt, sadness, etc.

If we can eliminate that style of thinking, it can do more (in my opinion) to help control our emotions than all the biofeedback in the world.

I've had fun, recently, picking the bearish side of the argument to your recent series of posts on high dollar inflows to the Dow. But that kind of analytical thinking help to prepare me for the possibility that the market would not continue to rally. As you noted, being open to that possibility helped you to make a great trade, yesterday.

Don't get me wrong. I meditate and I think that biofeedback has a role. But, if you have an expectation that is unmet because of your "shoulds" leads you astray, then you are using it to comfort you. It would be better, I think, to use it TO PREPARE YOU. To think analytically, unemotionally, and without biases.

Thanks for a great blog and great insights.

Brett Steenbarger, Ph.D. said...

Hi Bruce,

Great point about shoulds and eliminating rigid expectations as a way of moderating emotional responses. Glad your analyses helped you catch the recent consolidation following the strong upside action.


Caravaggio said...

I agree with you wholeheartedly, that getting locked in to a fixed opinion on the outcome of events can be disastrous. Even the mighty Soros, if you read his work, is extremely flexible in his trading approach, regardless of his apparent long-standing, broken record like sounding, views on the USD, borrowing, etc.

I don't necessarily think it's wrong to think in terms of 'shoulds' though. For example, we know the relationship between the USD and inflation is weak, so this 'should' is more of a 'could'. However, if we looked at the historical data and the relationship was strong and robust, then it would be more rational to have a stronger 'should' view. The same goes for the other two examples. It's the uninformed 'shoulds' that are really dangerous, but having informed opinions based on various hypothesis and outcomes of events, is a central tenet of fundamental investing. I believe the more short-term one trades, the less relevant this data becomes, and so it becomes more a game of focussing on what is happening right now, versus hypothesising about what will occur.

Brett Steenbarger, Ph.D. said...

Hi Caravaggio,

Nice distinction between informed hypotheses and uninformed shoulds. Thanks for the comment--


Jeff said...

Thank you for this great insight, Dr. Brett!
May I ask you a little technical question? How do you go about seeing what the majority of stocks are doing? Do you have a list of particular stocs that you check one-by-one, or do you watch some index to guage that?

Brett Steenbarger, Ph.D. said...

Hi Jeff,

I follow a basket of stocks that correlate well with the S&P 500. I also track a variety of sector ETFs and find that useful in seeing what's strong and weak.


Jeff said...

Thnka you very much. Could I ask you what which stocks are in that basket (or if you have posted that before?

Brett Steenbarger, Ph.D. said...

Hi Jeff,

I track five very highly weighted stocks from 8 S&P sectors to give me a basket of 40 stocks. Those stocks are mentioned in my early March posts on "Where's the Flow?" for various sectors--


Calex said...

Wow, I remember reading those very words many years ago. "Should" is a word that has no effective position in our vocabulary. Not just in trading, but in every facet of existence.