Thursday, May 24, 2007

The Psychology of Investing: How Investors Differ From Traders

Investment is different from short-term trading, psychologically as well as strategically. The shorter the time frame, the less time traders typically have to plan and research their trades. The intuitive, implicit recognition of patterns is a core skill for the high frequency trader. Many of the traders I have worked with in proprietary firms don't trade with a directional bias. They observe the flow of orders in the depth-of-market (DOM) display, the distribution of large transactions (buying vs. selling), and the waxing and waning of volume to frame trading ideas on the fly. As I've noted before, this rapid pattern recognition requires intensive exposure to multiple market scenarios, so that the high frequency trader literally develops a feel for market action.

The investor, on the other hand, seeks capital appreciation over a lengthy time period. There is plenty of time to research various markets and strategies, and this research is often key to the investor's success. Any investor will only see a limited number of bull and bear markets during their lifetime--not nearly enough to develop that intuitive, implicit grasp of patterns. As a result, the long-term investor must find an edge in his or her ability to identify strategies with an edge and then sustain the patience to stick with those strategies. Where the scalper is relying on implicit feel, the investor must follow conscious reason.

To understand the psychology of investing, it's helpful to look toward other areas of life in which we invest ourselves, such as relationships and careers. Can you imagine what would happen if we were to take a "trading" perspective on relationships or careers? We would set a close "stop loss" and exit the relationship or career whenever that was hit. No doubt, we'd wind up with an impoverished love and work life as a result. To sustain a romantic relationship or a successful career, we have to be able to ride the ups and the downs and remain rooted in our commitment despite difficult times.

This is equally true for the financial investor. Consider the long-term investor in stocks who was frightened out of the market during the scary drop late in February and early in March. Had the investor behaved like a trader, cut losses, and abandoned his or her strategy at that time, a great deal of opportunity would have been lost.

The experience of the Turtles suggests that it is not so easy to follow longer-term market strategies. The Turtles, recall, were given a purely mechanical system to trade, with rules governing when to enter and exit positions, how to size those positions, and how many different positions to take. Even with strategy mapped out for them neatly, the Turtles varied greatly in their returns, as recently noted in Curtis Faith's book. They could not ride out the inevitable drawdowns of the trading method.

To stick with a career, you have to believe in the value of your work; to stay with a marriage, you must remain grounded in the love that brought you to that other person. In no small measure, the successful professional or spouse relies on emotional bonds to ride out short-term adversity. The investor, unlike the trader, must bond with his or her strategies--must really believe in them and their intrinsic value. Look at the trend followers featured on Michael Covel's site: they are passionate about their method. Consider Warren Buffett or Jimmy Rogers: they truly value their (quite different) value approach to investments.

I've often heard advice from short-term traders: "Don't get married to a position." Investors, however, do enter into a kind of marriage: a marriage with their basic approach to markets. Frequency of exposure drives the rapid pattern recognition of the scalper, but it is depth of conviction that enables investors to stay their course. The key, in investing as in marriage and careers, is finding the right partner for that bonding and commitment--not just something you think can work, but something that captures your deepest beliefs; that you're willing to subordinate yourself to.


Guiding Principles of Trading Psychology

The Objective Basis for Subjective Knowledge

Reflections on Life and Markets


Caravaggio said...

Hi Brett, I operate as both a trader and investor, both with limited success, so I may well be wrong in my thinking, but here it is:

Surely we all have stop-losses in many aspects of life, including relationships. That is, there has to be a level at which it's better to get out and call it day ... that's not to say we should walk away at the slightest difficulty, but just that we need to appreciate when things are not working.

Likewise, for the investor who got washed out of the market dip earlier in the year, I don't know whether it's fair to say that they behaved like traders (short-termist) and that they just got spooked out of their positions for no good reason. They could have had a strong conviction behind their trades, but then the sequence of events could have rationally led them to take their cards off the table. Investors like Soros used to trade according to his convictions and what the market was telling him, not just convictions alone.

I haven't thought it through in great detail but perhaps the reason the successful trend followers all have strong will and the conviction to ride out the draw downs is simply because to succeed in this type of investing you have to take this attitude, by default. Those who don't don't make good trend followers can still be good macro traders (eg: Soros), and many who do have the conviction will still be wrong and get taken out by the market (nursing big losses, perhaps blowing up along the way). And then, by definition, we are only left with one group of investor in the successful category of trend followers - and we end up believing these are the traits we need to be good investors, but perhaps this is a kind of backwards perspective, a kind of trap of survivorship bias amongst the trend following school. I could be clearer but I hope this makes a little sense. thoughts welcomed.

all the best


Brett Steenbarger, Ph.D. said...

Hi Caravaggio,

I certainly agree that stop losses are necessary in all facets of life, from relationships and jobs to investments. The key ingredient of success, however, is the capacity to sustain a long-term commitment even through normal, expectable ups and downs.


Kunal Bhasin said...

Hi Sir,

I am a new small investor in Indian markets.Still in learning phase.

However ur article was nice to read.Can i request you further to write something on how to handle relationships.


Brett Steenbarger, Ph.D. said...

Hello Kunal,

Thanks for your note. I haven't planned any posts on relationships, but will consider the possibility!