Saturday, June 09, 2007

Attribution and Bias Among Traders in the Financial Markets

Perhaps the cardinal contribution of behavioral finance research is the elaboration of the ways in which people depart from strict rationality under conditions of risk and uncertainty. How we process information affects our behavior, creating situations in which we can risk our capital more for psychological reasons than for logical ones.

Much of how we process the world consists of attributions: qualities that we attribute to ourselves and explanations that we attribute to events. As human beings, we are driven to make sense of our world, and attributions are an important element of that sense-making.

One of the most basic attributions traders make is to their gains or losses. Are profits and drawdowns attributable to the self; the result of positive or negative actions that we take? Alternatively, do we attribute gains and losses to outside forces or to sheer chance? How we attribute the outcomes of our trading performances will necessarily play a large role in what we do about those performances. If, for instance, we tend to attribute gains to the self, but losses to bad luck, we might stick with faulty trade ideas, exacerbating initial losses.

In point of fact, research finds that people are reliably biased in their attributions, a situation that cannot help but affect traders. Football fans, for instance, tend to attribute their team's successes to skill, but their opponent's victories to luck. When CEOs successfully complete acquisitions and attribute the success to their own skill, they tend to become overconfident and make further acquisitions--which then realize lower returns. CEOs also tend to be paid more money when the share price for their firms increase, as boards (falsely) attribute the price move to the executive's skill. This, too, is reliably associated with subsequent CEO underperformance.

It is when we indulge in self-serving attributional biases, however, that trading results are put most at jeopardy. Social psychologists refer to the "fundamental attribution error", which is the tendency to over-emphasize personality-based explanations for other people's behaviors and minimize situational influences. When we're subject to the "actor-observer bias", we tend to attribute our own outcomes to situational forces, rather than to fundamental personality traits.

How does this affect traders? Traders with a self-serving bias tend to give themselves too much credit when trades go their way and rationalize situations that lose money. As a result, they are likely to become overconfident after a string of winning trades, raise their trading size/frequency, and place themselves at risk.

Indeed, a consistent predictor of trader failure in my own experience is the tendency to attribute losses to a shadowy "them": the large traders and institutions that supposedly manipulate the markets. In years of working with traders, I have never seen one succeed over the long haul who reliably blamed outside forces for losses. Those traders, in fact, are subject to considerable anger and frustration, which leads them to become impulsive--the well-known phenomenon of "revenge trading".

Reason dictates that there is a difference between a good trade (one placed with an edge in one's favor) and a winning trade (one that makes money), just as there is a difference between a bad trade (one that lacks an objective, positive set of expectations) and a trade that loses money. Sheer chance alone can create situations in which good trades lose money and bad ones happen to get lucky. The self-serving trader who overemphasizes the role of chance in losses creates a situation in which learning from experience becomes impossible.

But there is another kind of trader--one with an overinclusive attributional style--that tends to own losses and gains with equal fervor. By minimizing the role of chance, the trader attributes all outcomes to the self, feeling good when the profits are rolling in and becoming discouraged during (inevitable) periods of drawdown. This is the "illusion of control" documented in the research of a London Business School research team, who found that traders who thought they could predict markets shown to them (which were actually random price series) performed worse than less confident traders. The result is that you can reliably track traders' moods by their P/L statements.

Traders tend to blame their losses on such factors as "loss of discipline" and "overtrading" when, in fact, these are frequently the results of attributional biases. The majority of traders spend more time trying to understand market movements than trying to understand their own thinking about markets. An interesting line of research finds that individuals who experience increased emotion tend to shift their attributional styles, reducing their tendency to own negative outcomes. Successful traders not only need to be able to think about markets, but also think about their thinking. Awareness of a tendency toward bias can be a powerful antidote to biased decision-making.


How Traders Can Become Their Own Coaches

How Trader Personality Affects Trading


bwilhite said...

Dr. Brett,

This gives me much food for thought. I've been aware of these things before now, but you've given me some great categories to think about them. There's another bias I see that occurs and not just in trading. I have no idea if it has a name or not...The general idea is that some events or circumstances (not necessarily all) are the effect of multiple causes and not just a singular cause. However, it seems that we have a tendency to try to seek only singular causes.

So in trading, for example, we might ask, "Why did the S&P go up?" and we might answer, "The Fed stopped raising rates." But maybe in this instance there are many different factors...Reality is just so complex that simple models are usually insufficient. Whenever I watch MSNBC I always have to laugh at the way they try to summarize causes and effects in short sound-bites.

Anyway, just a thought and I wanted to thank you for the post.


spwoso said...

Great post. Michael Shermer (columnist for Scientific American and editor of Skeptic) has extended this theory into what he calls an "intellectual attribution bias". In a nutshell: we tend to view our own beliefs as grounded in reason and evidence, while others' beliefs are largely emotion driven. This seems to me to have relevance to finance/investing psychology. Put yourself into the day trader's mindset just before the dotcom peak, and then after the crash.

Shermer's particular subject in the following link is religious belief, so read only the first three paragraphs if this sort of inquiry offends you.

Brett Steenbarger, Ph.D. said...

Hi BW,

That's an excellent observation and is related to the availability heuristic in behavioral finance. We latch onto single, simplistic explanations--especially when we're under stress. That can lead us to miss broader underlying patterns. I've seen traders concentrate so highly on the order book that they attribute movements to shifts in bids and offers when in fact a move in a correlated market has set off program trades and a range breakout.


Brett Steenbarger, Ph.D. said...


I very much like the concept of "intellectual attribution bias". We tend to think that reason is on our side and that we're trading with an objective edge when, in fact, we've never actually put our ideas to the test. Traders see themselves as contrarians, not as part of the herd. But if that were the case, contrarianism wouldn't work so well!


bwilhite said...

Hey Spwoso....

just wanted to let you know that while the sub-title of Mr. Shermer's article probably belies his own attributional bias, the article per se doesn't seem offensive at all. It merely points out some interesting traits of human beings. (I'm a Christian myself, btw.)

These kinds of biases are all around us, constantly, and their are almost certainly intelligent, thoughtful, people on both sides of any given issue.

We could almost certainly apply this to trading....after all, someone else is always on the other side of our trades. And chances are good they're not a moron.

Isn't epistemology fascinating?

Thanks for the link. :)


Caravaggio said...

Superb article Brett, a real 'keeper'.

In the market place there seems to be a requirement for what I call 'second-order' thinking, for want of a better term; that is, thinking about one's own thinking in the context of what the market is thinking about what is happening. I believe Soros was and maybe still is extremely good at this.

The idea of the 'illusion of control' is bang on the money. I have tried to get away from letting my emotions track my p/l, but it is a struggle. I am coming to terms with it by rationalising that even if I was in a coin-tossing contest with no edge and I received +1 for a head and -1 for a tail, and the competition was run over 100 tosses, I know my emotions would track the results to some degree, because I like winning and don't like losing, even though I'd be fully conscious of the fact that I'll probably end the game at break-even. Maybe it is a personal failing, I'm not sure. Also, there is the emotional gain/loss associated with the fact that actual money is being won/lost in trading, and that in itself will generate various emotions...regardless of one's influence on the results.

I also like your last point about trader's blaming their lack of discipline for losses when other factors are the real problem. On my blog I track my weekly results and also keep track of my 'behavioural road map', which is in essence, a discipline scoring. So, far the correlation between discipline and trading results appears very weak, although strong discipline has likely played a crucial role in avoiding catastrophic losses. I urge everyone to mark their discipline scoring at the end of each day/week, separate to one's trading results. This is something you have full control over, and over the long-term, is can help to build a stronger trader. It also helps to better understand that all losses are not due to a lack of discipline (this just appears the case, with hindsight).

Brett Steenbarger, Ph.D. said...

Hi Caravaggio,

Thanks for the thoughtful comment. Great point re: keeping separate scores for discipline vs. P/L. I especially like your point that discipline will show up, not so much in trade by trade P/L, but in the distribution of P/L as you reduce large losers, ride winners, etc.

The second order thinking is huge. If you can stand apart from your own emotions, you can use them as information. If the market is starting to scare you out of a trade, chances are good others are feeling that way as well. That can be useful info!