Tuesday, November 13, 2018

How Overconfidence Derails Our Trading

Here's an observation I've made of both traders and investors--those with little experience and those who have been doing this all their lives:

They are at their best when they treat their ideas as hypotheses and continually update their hypotheses as price action, news, and fundamental data emerge.  Their focus is on what they would need to see to disconfirm their hypotheses.  That allows them to exit quickly and limit risk in adverse conditions.  It also enables them to take the opposite side of a trade should they observe a meaningful disconfirmation of their ideas.

The traders are at their worst when they treat their ideas as conclusions and dig in their heels in these views in the name of "conviction".  This leads them to interpret market information with confirmation bias, looking at data that support their views and minimizing information that might not support their ideas.  Such an approach leads to a loss of flexibility and a situation where the only effective stop level is pain.

One way we turn confidence into overconfidence is by crystallizing our observations into narratives.  Among portfolio managers trading global markets and strategies, this is sometimes pejoratively referred to as "macro story telling."  The trader observes information--perhaps fundamental, perhaps monetary, perhaps intermarket, perhaps price-action based--and turns these observations into a narrative.  "Stocks are going higher because economic conditions are improving and sentiment is bearish."  That could be a simple narrative.  It is not a tested set of relationships, and it is not treated as a hypothesis.  It is a conclusion drawn from limited pieces of information.

It's surprising how often traders with bullish or bearish biases can find information to weave into bullish or bearish narratives!  

Once the narrative has crystallized, it organizes our perception.  We see the world through the lenses of our narratives.  That makes us less sensitive to other, possibly more relevant lenses and information.  Seeing the world through our story-telling--and then justifying that in the name of confidence--is the height of overconfidence.  What we want instead are multiple hypotheses, each with shifting odds as information comes out.  At some point, the odds shift sufficiently that we can put on a trade.  But we are always updating those odds, and we are always aware of what would lead us to reverse that trade.

A great exercise is tracking your self-talk during the course of a trade.  Is your internal dialogue information-based, or are you grounded in a single narrative?  Are you flexibly assessing odds and possibilities, or are you looking for information to support your fixed view?  Or are you so self-focused and P/L focused during the trade that you never get the chance to update your thinking?  That often occurs when our "conviction" views suddenly prove vulnerable.

This is one of the great ironies of trading:  It takes unusual confidence to believe that we can outperform the world's most experienced money managers.  Taken too far, however, that confidence can ensure our failure.

Further Reading: