In this article, I look at how a pair of research psychologists have revolutionised how we think. I discuss how their work helps explain why a few traders are very profitable, while the majority struggle to make money.
At the end of the article, I have a few ideas for simple trading strategies.
The Undoing Project
Michael Lewis is well-known for writing about the financial markets. He has written The Big Short (about the 2008-09 house crisis), Flash Boys (about high-frequency trading), and also Moneyball (about the Oakland A’s and their statistical approach to baseball).
His most recent book, The Undoing Project, is a bit of a departure. He tells the story of two psychologists from Israel. This seems like a strange topic for someone who has made their name writing about the financial markets. However, the really unusual thing is that the work of these psychologists led to a Nobel Prize in Economics.
The psychologists profiled in the book are Daniel Kahneman and Amos Tversky.
Kahneman and Tversky’s investigated and discovered a large number of errors that we all make in our thinking. These errors are referred to as cognitive biases. Some of the best known are:
The Endowment Effect
This is the tendency of most of us to place a higher value on things that we currently own. In trading and investing this can be seen in the reluctance to sell poorly performing investments.
Any trader of my generation has the Financial Crisis 2008-2009 looming large. It was an outsized event because it almost crashed the world’s financial system. So any trading system that I develop and test must have to be analysed using data from 2008-2009.
Recent events are more powerful than older events. This bias can lead to the dangerous idea that current market conditions are going to continue.
One of the most bizarre biases. Researchers have consistently shown that our estimate of unknown things can be affected by an initial (unrelated piece of information). So when trying to judge how a trade will go, we can massively under or overestimate the potential for profits and losses.
The really interesting thing is that simply being aware of cognitive bias can give traders a big advantage.
Simple consistency beats expertise
In The Undoing Project, Michael Lewis describes how the Oregon Research Institute carried out a study into how doctors diagnosed patients. They developed a simple algorithm that was based on 7 factors that doctors used to identify a medical condition. They then carried out an experiment to compare how the simple algorithm compared to the doctors at diagnosing patients.
When they analysed their results, the researchers were surprised to find that their simple algorithm was as good or better than the doctors’ diagnoses.
There could be many reasons why a simple algorithm can beat experts. One possibility is that an algorithm is consistent and will not make careless mistakes that anybody can make. However, in addition to this, the work of Kahneman and Tversky has shown that these doctors were prone to cognitive biases. Instead of just relying on the 7 key factors, the doctors were apparently using other information. Unfortunately, it seems that this other information, in aggregate was not helping them make the correct diagnosis.
How I have made this mistake in my trading.
When I read this I immediately realised that I have made this exact error in my trading. Recently I opened a long trade in the Nasdaq 100. Instead of opening a full position decided to open a half position. The reason I did this is that I had been reading an article about a probable market crash.
Now in retrospect, having seen the market continue to strengthen, I am faced with the likely scenario of closing this trade with a reduced profit.
You might think that at least I made some money. But this too is a cognitive bias. Mathematically over time, a reduced profit is exactly the same as a loss.
As traders, we are in the business of predicting where the market will be in the future. A good way of doing this is to develop a robust trading system that has a positive expectancy. Armed with this system we can open and close trades in an organised and efficient way. However, I made the mistake of allowing additional information (the article about the market crashing) to affect how I traded. The insight of Kahneman and Tversky is that when people are given additional useless information it makes them disregard the useful information.
I am not saying that all market analysis is useless. But I am saying that the financial markets are far too complex for any article to explain. Therefore, it is impossible for us to know how significant the article is.
We all know logically that at any one time, many of the most brilliant, highly paid analysts at the world’s most prestigious financial institutions are wrong in their predictions. We can comfortably say that all of them are wrong on a regular basis. Despite knowing this, many of us still allow their predictions to affect our trading.
Do cognitive biases exist in the markets
We can be fairly sure that other investors will be falling prey to these cognitive biases. The biggest players in the markets tend to move together. Large mutual funds buy and sell the same stocks to avoid missing out. Round numbers
Markets are said to be forward-looking. This is undoubtedly true as they react to events that have not yet happened. Markets are also brilliant at adjusting to mathematical events. This can be seen in how they adjust when a share goes ex-dividend.
However, markets are very bad at assigning accurate probabilities to uncertain events. A huge range of possible future events could affect the price, the markets might have to weigh up the chance of an interest rate hike against a possible war in the Middle East. The markets cannot do this – they are forward-looking but are unable to predict the future.
How can we use this to our advantage?
The best way we can use the work of Kahneman and Tversky is to ensure that we are aware of our own cognitive biases. The first rule I am going to implement is not to allow any irrelevant information to affect how I trade my strategies.
Secondly, once we are aware of our own cognitive biases, we can design systems to take advantage of this. Using historical data as a guide, we can expect markets to continue to be imperfect at predicting the future. We can expect markets to continue to display extreme reactions and overshoot, become over-exuberant during bull markets and too despondent during bear markets.
I think the most reliable way of trading them is to use the approach described by the Oregon Research Institute. Develop a method and then stick to this method.
Some simple ideas to consider
A big advantage of simple trading strategies is that they are easy to follow. I always prefer to start with a simple idea and then add to it if necessary.
Or alternatively simple technical strategies such as buy when stocks are above the 200MA and go flat below. Or buy the Nasdaq when it is above the S&P 500.
If you are interested in testing your own strategies, check out the Tradinformed Shop to see the latest backtest models.
Please use the comment box below to tell me what you think about the article and let everyone know your thoughts about cognitive bias and trading.