Sunday, July 20, 2014

Trauma, Bias, and Financial Literacy: Three Topics to Start a Fresh Week

Hope your weekend has been a good one.  Here are a few topics that might get us started for the week to come:

*  I've heard from several traders who have taken position sizes well outside their comfort zones, lost money, and shaken their confidence.  As we learned from Naomi (above), recovering from a traumatic event is not something you can just talk yourself into.  My experience is that the traumatic responses of traders--while not on the scale of extreme anxiety-producing events that occur in military combat--have some similarities to what soldiers go through in wartime.  This is partly because the stress symptoms often precede the specific traumatic event and because second guessing, anger, and grief are common after the event.  This is why prudent risk management is so crucial to trading psychology:  it is the best preventive measure we can take to avoid overloading ourselves emotionally.  Otherwise, it becomes all too easy for drama to turn into trauma.

*  I'm not sure if it's great minds thinking alike, but I see that David Blair and SMB Training posted some perspectives on hidden biases in trading that I hadn't seen prior to my recent post on bias blind spots.  David, on his Crosshairs Trader blog, describes how developing a stock trading process can improve decision making.  As Tadas Viskanta of Abnormal Returns emphasizes, putting market activity into the context of one's life--and not the reverse--is an important way of avoiding emotional overreactions and biases:  "there is much more to life than investing".  One way to reduce bias is to operate with sound trading rules.  Here are some of the rules emphasized by Barry Ritholtz; here is his second group--very relevant to investors and traders alike.

*  Here is a very interesting post on the financial literacy of investors from David Bailey and research group.  That group has also posted quite pointedly on the dangers of overfitting when backtesting trading strategies (see this recent article from Jason Zweig on the topic, as well).  The area where I find traders most lacking in financial literacy is risk management, per the trauma observations above.  Here is an informative post on using the 2% rule as a risk management guideline.  Evaluating your trading like a trading system is evaluated is a good way to get a handle on risk management; here are valuable perspectives archived by Henry Carstens.  As one wise researcher once told me, "Every successful trader is a system, whether they realize it or not."  It makes sense to study the system behind your own trading; hence the importance of studying one's trading metrics.