Tuesday, September 25, 2007

The Psychology of Losing

A large body of research conducted by James Pennebaker of the University of Texas, Austin finds that the expression of emotion has long-term mental and physical health benefits. His book Opening Up is an excellent, readable summary of his investigations, with numerous practical applications.

One particularly interesting finding is that the venting of emotion alone does not help people deal with traumas and other difficult experience. Rather, it is placing experience into words--either through speech or writing--that helps us achieve a perspective that enables us to move on from difficult circumstances.

Study after study finds that, when people cannot give proper voice to their troubles, they experience significant health problems and increased medical utilization down the line. Perhaps this is why psychotherapy, online social tools, and religion confession are so popular in our culture: they are ways for us to process our daily experience--not just to unburden ourselves, but to find new views of our situations.

The relevance to trading is clear: It may not be losing that damages traders, but unacknowledged losing.

I recall one trader I met with who went through a nasty downturn in his P/L. He felt guilty about his losses and felt that he could not tell his wife, who was going through her own problems at the time. The more he hid the problems from her (and from friends), the more he felt stressed and upset--and the more his emotional state interfered with his trading. Only once we had a couples session and laid everything out was he able to clear the air emotionally and get back to trading basics. The losses were manageable in their size, but hiding them took too much of a toll.

Similarly, a trader who ignores a stop and turns a short-term trade into a longer-term hold is attempting to squelch the experience of loss. Instead, internal tension builds and helps the trader make further bad decisions, such as doubling down on the losing position.

Contrast that with the situation I described in my most recent entry on the Trader Performance page, where I look at the epistemological unit of a trader's thought. When a trade idea is based upon an anticipated market movement, not a single entry/exit, it frees the trader to anticipate a loss in advance and flexibly reverse a position. Psychologically, this means that a loss is processed before it even occurs. It is used as information that can help the trader capitalize upon the anticipated market move.

Increasingly, my trade ideas take the form of "what-if" decision trees that include the possibilities of initial, small positions moving my way and moving against me. The decision trees address adding to positions and scaling out of them, and they enable me to be wrong with the initial small position and still benefit from the larger idea.

By requiring yourself to map out these decision trees, you can process trading experience proactively and constructively. A losing trade is placed into a larger context in which it has potential value.

A trading journal at the end of the day then serves the purpose of reviewing performance, highlighting what you did right and wrong, and setting goals for the next day. Such a journal, too, has its psychological benefits. Pennebaker has found that the same benefits achieved by talking about one's feelings can be achieved by writing for 30 minutes in a journal.

I am increasingly convinced that how traders process experiences of loss--including extended periods of drawdown--separates those who come back strong and those who become bogged down and even traumatized.

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PS - I'm now forwarding links to worthwhile readings across the Web via Twitter. If you do not have the Twitter comments automatically sent to your reader, you can check out the daily reading links and indicator summaries on my Twitter page. The most recent five Twitters appear on the TraderFeed home page under the column "Twitter Trader".


Some Painful Truths About Trading

Regaining Your Trading Consistency

Inside the Trader's Brain