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.
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