Why Do Disciplined Traders Make Bad Decisions?

We've all known traders who lack self-control.  They react rather than act, making decisions impulsively, often based on those twin fears of missing out and losing money.  It's no surprise when such traders draw down.  In a very real sense, they trade their hopes and fears, not the markets in front of them.

But how about traders with excellent self-control?  I know many: experienced money managers with long histories of success.  Once in a while they make mistakes that they describe as rookie errors.  They don't seem fearful or reactive, yet they will chase bad prices or stick with losing trades too long.  What's going on in such cases?  Aren't discipline and self-control supposed to produce good trading outcomes?

An interesting window of insight into the bad decisions of good traders comes from research conducted by Maria Konnikova that identifies the limits of self-control.  Konnikova finds that people high in self-control tend to be more overconfident than others in situations where control over outcomes is limited, but perceived control is high.  In other words, those with high self-control can also fall victim to an illusory sense of control.  That leads to poor decisions.

What is particularly fascinating in Konnikova's work is that people with high self-control are most likely to overestimate their actual control in situations when they are experiencing positive emotions.  Konnikova notes, "...the positive affect that usually accompanies both the illusion of control and high self-control can be an Achilles heel of high self-control in certain environments with limited actual control, creating a feeling of overconfidence that translates into suboptimal decision making."  It's when traders are winning and feeling good that their confidence is most likely to morph into overconfidence.  That leads them to overestimate their control over market outcomes and make decisions based upon illusory--not actual--control.

What is the solution to this dilemma?  Konnikova explains that the self-awareness of those high in self-control can help them recognize that positive emotions are a threat to their control, thus cooling them down when their confidence is running hot.  This fits very well with observations I have made in the course of working with traders: often the worst decisions are made when the trader has just made money, not when he or she has drawn down.  We don't normally think of positive emotion as a risk factor, but in fact any experience that takes our attention from markets and leads us to focus on outcomes rather than process is likely to interfere with performance.

We commonly hear that traders should take the most risk when they have the highest conviction in their ideas.  That can work as long as conviction doesn't come at the expense of self-awareness.

Further Reading:  The Lack of Profits From Market Prophets
.