By: Tim Fortier — June 9, 2021
Trading is Hard. Here's How You Can Do Better.
And not because investors lack the technology. Today, you can choose to invest using a myriad of amazing technology platforms.
In addition, innovative products such as Exchange Trade Funds (ETFs) allow investors to invest in any part of the market, instantly, long or short, and for minimal costs.
On top of that, investors can now trade commission-free and benefit from fractional shares.
It is also not because investors lack information. Never before have we all had so much information available to us.
In the old days, the broker and the investment firm were the gatekeepers to the world of stocks bonds. No more.
The financial markets have become democratized. Thanks in large part to the internet, individual investors have easy access to company information and research.
On top of that, there are thousands of hours of instructional videos being downloaded daily providing investors with the knowledge and wisdom of successful traders, helping to speed up the learning curve.
Yet, despite this abundance, investors still struggle.
Because successful investing is much more than just picking winning stocks. To be a successful investor you must also master the mental game.
In the television series Billions, Wendy Rhoades combines an avid intellect with a keen understanding of human nature.
She used those skills to help Bobby Axelrod build his hedge fund from the ground up and now works as the company's star in-house performance coach.
We could all use our own Wendy Rhoades.
That's because emotions are THE biggest reason why so many investors fail. and humans tend to think in irrational ways.
Science has shown that we tend to make all sorts of mental mistakes, called “cognitive biases”, that can affect both our thinking and actions.
These biases can lead to us to extrapolate information from the wrong sources, all so we can confirm existing beliefs. Bias can even cause us to fail to remember events the way they actually happened.
These tendencies usually arise from:
- Information processing shortcuts
- The limited processing ability of the brain
- Emotional and moral motivations
- Distortions in storing and retrieving memories
- Social influence
There are nearly two hundred cognitive biases that can trip you up on your path to success. This infographic displays the 188 known confirmation biases in existence.
It can seem almost overwhelming if you dwell on this.
To succeed as an investor, you must overcome not just the vagaries of the market... but also of your own brain that is hard-wired to fail.
While fear and greed are more generally discussed within the context of emotions and investing, I wanted to discuss a few of the common patterns that often prevent investors from achieving success.
Brett N. Steenbarger, Ph.D. is the author of The Psychology of Trading and has interviewed hundreds of traders. In his white paper, "Behavioral Patterns That Sabotage Traders," Steenbarger identifies some of the common patterns that interfere with trading.
In his findings, most trading problems are varieties of performance anxiety.
Performance anxiety occurs when a performance that is usually automatic becomes the object of excessive scrutiny. This attention to the performance creates an interference effect, in which the performance can no longer flow naturally.
In practical terms, a constant focus on one's P/L statement rather than the process and the reason behind the investment can cause an investor to make irrational decisions.
Dr. Steenbarger also discovered that performance anxiety occurs as much during times of market success as during times of market loss.
He found it's common for traders who are good at taking (appropriate) losses, to become fearful when they book a gain. Those traders end up taking profits prematurely (i.e., before reaching their profit targets).
Interference effects following strings of losses are no more debilitating than interference effects from the pressure traders feel when making money.
Steenbarger also found that perfectionism is the most common source of performance anxiety among traders. Here's how that works.
Traders tend to be achievement-oriented and often set lofty goals for themselves.
These performance goals cause tension when they go unmet.
A better approach is to replace performance goals with process goals. Instead
of setting a goal of making $100,000 a year, a trader could, for example, set a
the goal of following a trading plan (entries, position sizes, exits) on 90+% of all
At the end of the day, all an investor can do is control the process they use to make investment decisions. If the process is sound and tested in the rigors of real-world application, then the consistent application of the process should yield a profitable outcome.
If you notice a common thread it is the focus on the investment process that helps eliminate the debilitating effects of human emotions upon investment results.
Even here there are challenges. No single process will work 100% of the time. Humans tend to think in irrational ways. That particular holy grail does not exist.
Accept that and move on.
What will you do if your selected investment systems produce a string of losses? Will you jump ship, looking for the next "perfect system"?
This is what most investors do. And thus they never get to enjoy the profits that can be had from following a proven process.
For example, relative strength investing is a favorite strategy of mine and is used widely here at TMI. James O'Shaughnessy, in his classic book, What Works on Wall Street, details the results of relative strength from 1926-2009.
A portfolio of stocks with the best six-month performance compounded at 14.11% versus 10.46% for his All Stock universe.
Further, this relative strength portfolio outperformed the benchmark in 68% of single-year returns, 79% of rolling 3-year returns, 87% of rolling 5-year returns, 95% of rolling 7-year returns, and 98% of rolling 10-year returns.
But notice, that while the outperformance of relative strength is significant in the long run, there will be periods where it underperforms the general market.
One way to combat the psychological tendency to abandon a proven strategy during periods of underperformance is to diversify by process.
For instance, the use of a short-term swing strategy or a non-directional options strategy may complement a longer-term relative strength system and help smooth out portfolio ups and downs.
The key takeaway here is that you already have all the tools you need.
By focusing on and implementing a proven investment process, you significantly improve your chance of overcoming human emotions that may sabotage your results.
Here's to your success.
Editor, True Market Insiders