In this series of three posts, behavioural psychologist Paul Davies opens the bonnet on our personal trading engine—our brain—to uncover the secrets of how we act as individuals, how groups trade and how we can implement strategies for better trading. Read part one here.
In the last post, we took a peek at our personal decision-making engine and explored how understanding our brain can lead to employing better strategies when trading. Whether you’re fully onboard with the thinking behind behavioural finance, or retain a healthy scepticism, adopting the dual-self theory we discussed previously can undoubtedly provide a useful way to check your own investment decisions. In this post, we’ll concentrate on you as an individual trader and review what behavioural techniques can help in times when your emotional brain takes the reins.
The first step to becoming a behavioural trader is to acknowledge we’re not consistent in our decisions. Our mass of neurones are as volatile as the markets, and there are countless biases we’ve adopted over millions of years of evolution which kick-in when they’re not wanted. Together they result in decisions differing month-to-month, even when all the available information is identical.
If you’ve picked up any of the popular books on behavioural economics, or watched TED talks from behavioural scientists such as Schlomo Bernartzi, Dan Ariely or Gern Gigerenzer, you’ll have heard terms for these biases such as loss aversion, hyperbolic discounting, present bias, anchoring, framing and many more. While diving into detail about all the insights from behavioural economics is beyond the scope of this short post, I thoroughly recommend picking up a copy of ‘Nudge’ by Richard Thaler and Cass Sunstein as a way of familiarising yourself with the array of biases which affect our daily choices.
Acknowledging we’re inconsistent when it comes to making decisions is part of the broader challenge of overcoming one of our biggest cognitive illusions, our bias to over-estimate our own abilities. Being more optimistic than realistic is often a good strategy to adopt in life, it allows us to embrace challenging goals and stay committed to achieving them, but it can also lead us to think our will-power is strong enough to make a rational decision when faced with high inflation, low interest rates and lousy stock market returns.
Don’t think this applies to you? Take a moment to evaluate the following abilities and characteristics, and judge where you stand in relation to everyone else: driving ability, getting along well with others, how attractive you are and how honest you are. For each, do you think you’re above average, average or below average? When Dr Tali Sharot, a cognitive neuroscientist from UCL, put this to the test she found most people thought they were above average on most scales, a result which is statistically impossible. When it comes to trading, having the humility to know you’re as vulnerable to decision biases as everyone else gives you the power to do something about it. Ben Inker, Head of Asset Allocation at Wells Fargo, summarised this adroitly in a recent Bloomberg article; “For most investors, the best use of behavioural insight isn’t as a guide to spotting others’ flaws, but as a reminder to stay humble.”
At last, we’re in the right mindset to build our behavioural checklist. At the top of our list is to engage our rational brain before events occur, and make decisions before our emotional brain wakes up. Just as Odysseus had the wisdom to tie himself to the ship’s mast before reaching the sirens, taking time to evaluate potential futures means we can prepare commitments to overrule emotions that bubble-up in the moment.
One of the simplest techniques to override reflex decisions is to create a set of ‘if-then’ plans for key scenarios. These take the form of ‘If situation X occurs, then I will do Y’. For example, 'if I see my portfolio fall by 5%, then I won’t stop trading’; or even ‘if emerging markets fall to below 20%, then I will consider buying and not selling.’ These are naive examples from a psychologist, not a financial expert, but the point is to use your trading knowledge ahead of time to build a set of statements, so they act as an automated algorithm when the time comes.
Instead of relying on your brain at a time when it’s awash with neuro-chemicals designed for fighting or fleeing, you can move to your set of ‘if-then’ statements for instruction.
It may sound childish, but I’ve met investment experts who wish they had set up such plans before the results of the UK Referendum and the US Election. Much like how the military practice routines to make sure they react first and think second in conflict scenarios, the strategy of creating a simple 'if-then' plan has shown to be effective in nearly all areas of life from eating more fruit, getting more exercise, to improving academic performance as well as making better investment decisions.
Another useful technique when market events lead to heightened emotion is to force your brain to remain focused on the bigger picture. We know the return of our entire portfolio is what matters, but short-term forecasts easily trigger us to focus on individual assets and tempt us into making short-term decisions. When we make trading choices based on sentiment-led trends of fear and greed, ‘we can do to ourselves what the bad general can do to his army – make a series of local choices that each appear to be advantageous but which collectively lead to a bad global outcome’ (Read, Loewenstein and Rabin, 1999). For example, imagine you buy an investment for £5,000, but you see it drop to £2,500.
Many hold the investment because selling at this point is a confirmation of the loss, which is a painful idea for our brain to accept. This decision is based on ‘narrow-bracketing’, letting the performance of individual investments outweigh our long-term strategy. Behavioural economists call this the disposition effect, and it leads investors to sell winners, hold losers or shy away from continued investment when assets become undervalued. Try and take notice when your brain shifts its focus from your long-term campaign to short-term skirmishes, and question if you should overrule your instinct.
As a useful summary, looking back to the work of psychologist BF Skinner gives us a framework for applying our techniques. The three principles he proposed to promote self-management were (i) modify your environment, (ii) monitor your behaviour, and (iii) make commitments. If you know you’ll be affected by short-term forecasts, change your environment to block these channels in favour of articles, talks and events about long-term strategies. Monitor your decisions against your long-term goals and adapt when a decision moves away from them. And commit to investment strategies ahead of time by creating a set of personal ‘if-then’ plans to fall back on when the serotonin floodgates open, and your emotional elephant of a brain comes charging in to ‘save the day’.
Trading fast and thinking slow: Thinking outside the herd to give you the edge
In the final post in this series, we’ll turn our attention away from the individual and look to how groups make decisions and how this can offer insight a savvy trader can exploit.
Paul Davies is a behavioural psychologist consulting in the fields of health and finance. He has worked alongside companies such as Santander Asset Management, Old Mutual Wealth, James Hay Partnership, Equiniti and Killik and Co.