The Mind of a Trader
By Alpesh B Patel
Alpesh is the founder of hedge fund, Agile Partners and the Author of Investing Unplugged, co-founder of InvestingBetter.com trading CDROMs and behind the Alpesh Patel Sharescope Special Edition. He has written over 10 publications relating to investment and online trading.
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I am a trader. For the last three years we have returned an average 40% gross return. You learn a lot about trading psychology when you are managing other people’s money. But, when like me, you have also had over 200 columns published in the Financial Times on investing, you get to learn through emails which are the biggest private investor’s mistakes. So let me share the lesser known costlier ones with you.
Optimism bias is a major problem traders face. It is the tendency to believe one is better than average. For instance studies reveal 95% of drivers believe they are better than average. Over-optimistic trader underperforms. This bias leads to overconfidence in predictions. Experts are particularly prone to this; expert predictions about financial markets, especially about interest and exchange rates have been shown in experiments to be generally quite inaccurate and often less accurate than lay views. In one study dustmen were better inflation and GDP predictors than finance ministers. This also confirms many traders' beliefs that they are the best managers of their investments and not 'expert' fund managers.
As online traders you must be willing to more readily accept you may be wrong about a stock despite all your online research. Set price levels at which you will accept you were wrong; let the price prove you right or wrong and then act on it.
Another lesson I take from this finding is that we ought to place less reliance on stock 'experts' and their stock picks. I do not know what stocks are going to double next week, no one does. We can only guess probabilities. Experts' pedestals need lowering, they 'know' far less than people think.
Risk aversion biases suggest traders tend to be risk averse when facing a profit and risk loving when facing a loss. Consequently they let their losses run and take their profits prematurely.
I would advise traders with a losing position to consider if they would buy more stock at those price levels. If not, it may be time to sell. Also could you reinvest the money in another stock for potentially better returns, if so - do it rather than falling into the common trap of hoping losing stocks will rebound.
Similarly, when facing a profit, ignore how much you have made or how your other positions are faring. Many traders tend to go for higher risk trades after a string of losses in an attempt to eradicate their past losses, they then take a quick small profit to break their 'losing streak'. Instead remember that your other past and present trades are irrelevant to when you should exit your current stock position.
Herding is yet another fascinating trader problem. People tend to regret decisions more that go wrong if they were minority decisions. They tend therefore to seek other like-minded people to reinforce their views, perhaps in investment clubs and chat sites. The problem is that the quality of decision is not necessarily improved and on the contrary can lead spurious trade selections, especially if those with contrary views are silenced because of confirmation bias. The key is to do your own research and be confident in it, and not simply because your own view is repeated by others.
For instance, if you bought $5,000 of XYZ shares at $1, then another $5,000 worth when the stock halved in price to 50c, the point at which you would break-even moves from $1 to only 66c. It is tempting.
Don’t do it. Trading is not about ‘getting a win’ on any one trade; it is about limiting your losses and maximising your gains over all your trades. If you ‘average down’ then you’re simply less diversified and own twice as much of a company whose price keeps falling. That’s fine if you think it is the best place out of 3,000 listed stocks for your money, bad if you just want to ‘get a win’.
Moreover, novice investors often confuse price with value. A falling price does not mean a cheaper stock. The value of a stock can be measured by earnings, assets it holds, and other ways. A falling price could reflect simply lower expectations of value.
The investor should instead consider ‘in which stock can I best make a return’? It would be great coincidence if the answer is ‘the very same one which has been returning me a loss.’
Another favourite among bulletin boardsters is ‘dollar cost averaging’. It is a sensible idea but overstated. For example, if you had $12,000 that you wanted to invest in a stock, they would tell you to invest $1000 per month over a year, rather than investing the whole amount immediately. The rationale is that you will automatically be purchasing more shares when the price is low, and fewer shares when the price is high.
However, since 1950, dollar cost averaging with the S&P 500 has actually failed to beat investing the lump sum at the start of the year in two years out of three.
Of course, cost averaging will win if your start date falls right before a dramatic crash (like October 1987) or at the start of an overall 12 month slump (like most of 2000).
Since we are playing with numbers, there are two further tricks the markets play worth remembering.
First is the ‘it’s down 40%, so it only has to rise 40% to break-even’ mistake. If a stock moves down, say, 40%, then it has to rise more, a whopping 66%, before you are back to break-even. So think again, the next time someone on a bulletin board argues the stock is ‘only down 40%’.
Equally, if the stock moves up 40%, then it only has to move down just 28% for you to get all the way back down to break-even. So a 40% rise does not afford you as much protection from a downturn as you might have thought.
I did a straw poll of 25 private investors asking them the answer to the above ‘40% problems’. Two got the right answers.
Yet another trick the market plays with numbers is the ‘a stock that drops 90% can’t go much lower’ myth. If a stock drops 90%, you may well reason it does not have further to fall and is worth ‘a punt’ or worth keeping hold of, or even buying more. Indeed, some investors only look for such stocks.
Well, if a stock is down 90%, you would probably concede that it could easily move down 95%. What is the change in value of your investment if that happens? No, not 5%, but 50%, because if a stock drops 90%, then halves, it is down 95%.
The problem is private investors often make investment decisions on where the price once was ($1), rather than where it is now (10c) which is why they reason, ‘surely being down 90%, it does not have much further to go’.
Would you normally be willing to accept a 50% loss? Perversely we are more willing to accept a relatively large loss (50%) if we have already suffered even larger losses (90%).
The professional investor does not think like that. The correct reasoning should be, ‘where can I get the best return for the risk I am willing to take at this point; in this investment or some other?’
Sadly, private investors often have a fixation for making back their losses in the same stock in which they incurred them.
So what’s the answer? It’s a man’s world – in finance anyway. There can be little doubt about male dominance when only one out of a hundred of the UK’s largest companies are headed by a woman (that one company owns this paper by the way). Even in the US, it’s a similar proportion of women who head Fortune 500 companies.
How ironic. Recent research shows 46 per cent of all US businesses are owned by women, and employment at women-owned businesses is growing at 18 per cent, compared with 8 per cent for all companies, according to business magazine Forbes. Actually, US women have an average net worth of £1.96 billion compared with the men, at £1.45 billion.
And when it comes to investment, research also shows women make better investors than men. Luckily for men, there is much they can learn from women. What is it women do in stock picking, research, trading, that produces better results and how can men use the web to close the gender gap?
Women’s portfolio’s earned 1.4% annually more than men’s did in a study* of over 35,000 investors by the University of California at Davis. Indeed single women earned 2.3% annually more than single men.
Poor male performance is due to over-trading according to the study. Men trade their accounts 45% more often than women. And single men shuffle their holdings 67% more than single women. Perhaps the adage about men’s fear of commitment is true after all. The answer then is take the opinion of a woman.
Mark Twain had the best advice for the investor who, loaded with market myths, becomes overly confident in his abilities: “April. This is one of the peculiarly dangerous months to speculate. The others are July, October, December, January, March, May…”
Alpesh B Patel