Tuesday, July 15, 2008

Keeping Open Minds in Roiling Markets: Overcoming Endowment Effects in Trading

Please mark this down: We make our greatest trading mistakes when we start managing our emotional responses to markets and stop managing our trades and portfolios. Fear is the enemy of flexibility. When we react out of fear of loss, we are deer in headlights. When we react to a fear of missing a market move, we lurch into trades impulsively, often at the worst times. In each case, we're acting in a way to assuage the fear of the moment, not to address opportunity or its absence.

Yesterday was a perfect case in point for me. Noting that smaller cap stocks held up reasonably well late last week and seeing that we had a nice overnight bounce in stocks thanks to the announcement of the government's plan to support FNM and FRE, I was leaning to the long side at the start of the day. I didn't have an overnight position and decided to let the market talk for itself once trading commenced.

As you can see from the distribution of the NYSE TICK above, sellers dominated from the outset. Many more stocks were transacting at their bid price than at their offers. The blue, five-period moving average of the TICK (which is scaled at left) spent essentially the entire day below the zero (pink) line. That is quite unusual. Just seeing that extreme distribution of real-time sentiment was enough to keep me out of trouble. My hypothesis about the day's action was wrong; seeing that quickly--and having the mental flexibility to acknowledge it--was key to the day's success.

Once we're in a large position, it is more difficult to maintain that mental flexibility. The endowment effect noted in behavioral finance research appears to have a basis in brain physiology, affecting decision making by overweighting perceptions of possible loss or risk. When we have positions in the market, they become OUR positions, and we place special value upon them. When we have large positions in the market, we've doubled down not only in our financial commitments, but most likely in our emotional ones as well.

The mindset I have found most helpful for combating the endowment effect is to frame each of my trade ideas as a hypothesis--not as a conclusion--and to clearly articulate the conditions under which my hypothesis is not validated. To be sufficiently committed to a hypothesis that you will test it with trades, but to not be so wedded to it that you ignore the data coming at you: such a scientific stance lies at the heart of trading success, enabling us to focus on managing our money, not our fears.


Trade Like a Scientist - Part One, Part Two, Part Three

Attribution and Bias Among Traders