Saturday, December 26, 2015

The Root Cause Of Traders' Emotional Problems

So now I'll explain why traders often deal with emotional disruptions of performance and why psychological techniques to deal with those disruptions often do not address the true causes of the problems.

It's really quite simple.

Returns in financial markets ultimately derive from several overarching factors, such as momentum (persistence of directional movement); value (tendency of price to oscillate above and below one or more value criteria); volatility (absolute price movement); and carry (returns derived from holding the asset, as in the case of dividends or roll-down).  

What makes asset managers different from traders is that asset managers are attempting to garner returns from all factors.  They are not necessarily attempting to predict which factor will provide the best returns over the next time period.  Rather, they will construct a portfolio that will achieve favorable returns across a variety of possible factor-based scenarios. Central to asset management is the idea of portfolio rebalancing.  If you don't rebalance a portfolio, you will be top heavy with respect to whatever factor has most recently performed well and underweight factors that have not recently performed.  This leaves a manager vulnerable when patterns of dominance among factors shift.

The trader tends to focus on one factor and one factor only.  Perhaps the trader is a trend/momentum trader; perhaps the trader relies on patterns of mean reversion; or builds a dividend portfolio.  Invariably--and this is especially true of short-term traders--the trader attempts to reduce returns to a preferred factor.  In that sense, the trader is a bit like the blind men trying to describe an elephant.  One focuses on the tail, another on the leg, yet another on the trunk. No one truly captures the look of the elephant.

When a trader declares that he or she is, say, a momentum (momo) trader, the odds are good they'll make money when momentum is a dominant factor and lose money when value and other factors dominate.  It will have nothing to do with psychology, though the losses may bring all sorts of psychological consequences as well as monetary ones.  The trader will lose for the same reason that the blind man will get the elephant wrong:  simplicity has veered into oversimplication.

Once a trader declares that he or she is an X trader, where X is a stand-in for a factor exposure, the die is cast.  There will be winning and losing and uneven performance.  Just as the trading is going well and risk-taking increases, factor dominance will shift and losses will mount.  When trading is going poorly and the trader finally takes a new approach, the old style will return to favor.  All of these generate frustrations and losses.  The core problem, however, is the need to fit markets into a style of trading rather than finding ways to trade that fit with market behavior.

No amount of discipline, mindfulness, positive self-talk, emotional control methods, or goal-setting will make a bit of difference if you're taking one feel of an elephant and trying to figure out the whole.

During 2015, the greatest change in my own trading has been the adoption of a cycle-based framework for thinking about markets.  In some phases of market cycles, momentum/trend dominate.  In some phases, we see mean-reversion/value.  Some phases of cycles display higher volatility and correlation; other phases exhibit lower volatility and correlation.  Knowing where we're at in a cycle determines whether the trading will trade price movement or fade it; whether regimes are continuing or shifting.

Cycles don't give us an infallible picture, but they do allow us to move around and feel around before we guess what the elephant looks like.  We experience emotional disruption when we try to force markets into a rigid framework.  A flexible framework allows us to not get bent out of shape, as we adapt to market cycles rather than expect markets to conform to our trading preferences.

Further Reading:  Living Your Calling