The Greatest Psychological Problem Affecting Investors and Traders

The Greatest Psychological Problem Affecting Investors and Traders: 

We plan trades in one state of mind and track risk/reward in another. To adopt the language of Kahneman, we think fast and we think slow. Our slower analytical reasoning helps us develop ideas and our faster pattern recognition alerts us to threats and opportunities. It is when our faster information processing collides with our slower reasoning that we can find ourselves failing to trade our plans, even after we’ve spent considerable time planning those trades.

How can we align these modes of cognition? The usual answer is that we need to impose discipline and rigorously follow a time-tested “process”. It turns out that is often misguided advice. To solve the greatest psychological problem affecting investors and traders, we need to clearly identify the source of our cognitive/emotional mismatch.

When Psychological Problems Have Non-Psychological Causes

We often assume that when problems manifest themselves with psychological expressions, they must be psychological problems. That is often not the case. I recall a situation a few years ago in which a young woman came to see me about a persistent bout of depression. She had sought therapy, and she had tried medication. None of those things helped her. Most recently she found herself feeling down because her face had broken out in acne and she didn’t like the way she looked. Her history was not remarkable for depression or any other psychological problem and she didn’t have a history of skin problems. I suggested a blood workup and, sure enough, she had a massive endocrine imbalance.  Once the imbalance was corrected, there was no more depression, no more acne. The psychological problem had a purely physiological basis.

Family therapists are all too familiar with situations in which the psychological problems of presenting patients reflect wider dysfunctions within broader, family systems. One woman came to me with persistent anxiety problems and practically begged for counseling and medication to help with her “negative thinking”. As our interview progressed, it became clear that there were emotionally and even physically abusive dynamics in her marriage that she was not acknowledging to herself or others. I encouraged her to take a vacation and visit her sister and, sure enough, the anxiety abated. Her sister shared her own concern about my client’s marriage. That led to a more prolonged separation and a realization that the anxiety was not simply her own psychological 

When investors and traders become anxious or frustrated and make decisions out of impulse rather than planning, they naturally assume that *they* must have the problem; that the problem is one of impulsivity. They keep journals, make checklists, set rules, engage in behavioral exercises, and desperately try to rein in their fast-thinking minds. The problem, however, does not go away, because it is not a psychological problem.

Why Investors And Traders React Emotionally To Financial Markets

A key to understanding the cognitive/emotional mismatch of market participants can be found in an important paper from Easley, Lopez de Prado, and O’Hara. We typically think of markets as trading in chronological time. Look at most any market chart and you’ll find time on the X-axis. When we view markets through the lens of chronological time, every day is the same as every other one, opening and closing at the same time.

Easley, Lopez de Prado, and O’Hara suggest, however, that markets do not actually trade via a chronological clock, but by a volume clock. In other words,Lopez de Prado explains, markets are best captured in event time, not the time captured by the movement of earth around the sun. Because events, including volume, are ever-changing, markets themselves are not stable–and this lays the groundwork for emotional instability.

Recent trading in U.S. stocks provides a powerful example. Consider the chart at the top of this post. It describes the ES (S&P 500) futures contract over a two-day period, Thursday and Friday of August 20th and 21st. The data points on the blue line represent closing prices after every 500 price changes (ticks) in that index. In other words, the X axis of the chart does not reflect uniform time periods; 500 price changes is the event unit being used to capture the market’s clock.

Now as it turns out, there were almost 140 event time units for Friday the 21st alone. The prior Friday, in a much quieter market with about one-third the volume, there were only about 40 event time units. As the red line in the chart above captures, the oscillations from “overbought” to “oversold” and back again were very frequent during the recent two-day period. They were much less frequent just one week previous. For all intents and purposes, the market that traded one week was fundamentally different–in volume, volatility, and directional movement–than the week previous.

Imagine a hearing-impaired couple on a dance floor with one slow dance number playing after another. The DJ suddenly changes the music to hip-hop/dubstep and our couple continues their foxtrots. That is the situation of the trader who is event-time impaired. Failing to recognize that the market’s music has picked up, the trader finds that the trades that had worked earlier are now grossly out of step with market action. Markets blow through the trader’s stop out levels; they continue to move much farther than anticipated after profitable exits.

The hearing-impaired couple, now foxtrotting while others around them are break dancing, feels a complete mismatch. Their sense of being out of step, out of place, leads them to feel uncomfortable and lose any sense of rhythm whatsoever. Similarly, facing far more rapid oscillations between overbought and oversold conditions per the chart above, even the most tone-deaf traders intuit that they are out of step, out of place. They become anxious and stressed, sensing threat. They become frustrated, as what had been working no longer works.

Their problem is not a psychological problem. Rather, it’s a problem of failing to adapt to changing markets, which brings psychological consequences. All the behavioral exercises and positive self-affirmations in the world won’t help our hapless dancing couple and won’t help traders out of step with markets. If you’re calibrated to an unchanging chronological clock and markets shift in event time, you’re going to be left behind–and that will lead to performance-related stresses.

How To Find Greater Cognitive/Emotional Alignment

If our dancing couple were given hearing aids, they would quickly recognize when waltz music had shifted to contemporary urban sounds. They might not choose to try their hand at hip-hop dancing, but at the very least they could get the hell off the dance floor and save themselves considerable discomfort. Similarly, investors who can amplify their hearing of market rhythms in event time have the opportunity to respond constructively to situations as change occurs.

So how can we function more effectively in event time?  Here are a few simple and relevant tools that can be tracked by market participants:

Volatility – The VIX is a measure of volatility implied by options pricing for the S&P 500 stock index. We can also measure realized volatility in terms of average daily price movement for any asset–the percent change from high to low prices. When we shift from one volatility environment to another, this is a clue that markets are changing in ways that will require adaptation on our part. – Volume is often highly correlated with volatility.  Indeed, my back of envelope calculations suggest a massive correlation of .84 between daily volume in SPY and the daily realized volatility of the SPY ETF during 2015. Volume this past Friday was over 340 million shares; it had been averaging about 114 million shares per day before that during 2015. When volatility expands, it means new participants are coming into the marketplace–and that tends to move markets directionally. Our portfolios become far more volatile–and potentially far riskier–when we move to high volume/high volatility regimes.

Correlation – In normal times, different investments move differently. For instance, through much of recent months, we’ve seen strength in some stocks (consumer-related) and weakness in others (commodity-related). Similarly, we’ll see different assets track different price paths. When market regimes change, correlations will often rise in response to a dominant theme: quantitative easing abroad will lead to a broad rally of the U.S. dollar against many currencies; economic concerns regarding China will lead to declines across almost all stock sectors. An expansion of positive or negative correlation tells us that our portfolios might become less diversified than we expected–a useful hearing aid.- Broad market weakness typically does not come out of the clear blue. Typically, one or more sectors will display unusual weakness before the weakness infects all shares. In 2000, the weak sector became technology shares, especially those linked to the internet; they bombed well before the broad list of Dow blue chips. In 2007-2008, the weak sector was banking, as related to housing. It started its extended decline well in advance of the other blue chips. Most recently, it’s been emerging markets, high yield credit, and commodities that have been the canaries in the coal mine. When there is unusual weakness in part of the world or part of the stock market, there is the possibility that the infection will spread.Breadth Deterioration – I have yet to see a significant bear market that has not been preceded by protracted deterioration of breadth in the stock market. When the market peaked in March of this year, my stats showed 241 stocks across all exchanges registering fresh annual highs against 20 new lows.  At the May peak, that number declined to 116 highs against 21 lows. At the July peak prior to the recent decline, we showed 97 new highs and 203 lows! When a relative handful of large cap shares keep the averages high even as the broad list of stocks weakens, we have a useful heads up that the rising tide is no longer lifting all boats and may be ready to come in.

When we are open to shifts in event time and accompanying changes in how markets are trading, we no longer have to dance out of step in our investing.Perhaps most important of all, we can come to recognize that our emotional reactions to markets–from frustration to fear–constitute information, not problems. Very often, we first intuit that we’re out of step with markets before we consciously identify the source of our misalignment. That intuition takes the form of a fight-or-flight emotional response: we sense that the environment is no longer as stable or secure as we thought. When awareness of our emotional responses prods us to further and deeper analyses and not impulsive actions–when fast thinking can catalyze better slow thought–we can be as responsive to shifting marketplaces as skilled entrepreneurs are to theirs.

Note: I gratefully acknowledge the contributions of Marcos Lopez de Prado to some of the ideas expressed in this post. His websiteis a veritable treasure trove of ideas for those interested in applications of quantitative finance.