Janice Dorn, MD, PhD
Neuropsychological Trading Coach
Janice Dorn, M.D., Ph.D., has been a full-time futures trader since 1994. Doctor Janice holds an M.D. in psychiatry and is board-certified by the American Board of Psychiatry and Neurology in general psychiatry and addiction psychiatry. She holds a Ph.D. in brain anatomy. A graduate of Coach University, she is a pioneer market psychiatrist and financial neurobehaviorist. Doctor Janice has written over 500 articles on the financial markets and coached over 600 traders worldwide. She is the Global Risk Strategist for Ingenieux Wealth Management Group, Sydney, Australia.
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Faced with the choice between changing one's mind and proving that there is no need to do so, almost everyone gets busy on the proof…John Kenneth Galbraith
Following last week's Trading Wisdom on decisions and decision-making, it is time to put on our financial neurobehavioral hats and learn another thinking bias. You will recall the bias of mental accounting, so colorfully depicted by The Man in the Green Bathrobe. We also spent a considerable amount of time on the overconfidence bias.
As a reminder, cognitive biases are about the way we think when we make decisions. Trading is all about making decisions, and decisions are made by the brain. It is the communication between the primitive emotional rat (limbic) brain and the higher-thinking rational (cortex) brain that determines how biases are formed, maintained, and applied in trading and investing decisions. You are what you think and believe, and your trading decisions are a reflection of your thoughts and beliefs.
I have been privileged to work with hundreds of traders in various stages of development and expertise, and have found that biases are among the most challenging aspects of trading because they are, in large part, ingrained deeply into the wiring of the trading brain.
Such statements as "I love this stock," "The dollar is just going to keep going lower and lower," or "The ES has to move up today" all reflect a form of bias called the status quo. What does this mean to the trader and his or her position? Once a person has decided that things just have to be a certain way and that they are going to continue in the same direction, that person decides on a specific course of action. Unless one is highly skilled and has trained his or her trading brain to be flexible and think in probabilities, the status quo bias will persist.
All of you are aware of so-called permabears or permabulls who remain either bearish or bullish despite every evidence that their choices have little if any chance of success in a given market condition. They will read every piece of information, study the most obscure writings, and search constantly for indicators or any signs that their bias is correct. Interestingly, because there is no shortage of opinions about the market, if they look long or hard enough (as they usually do), they will find some fact, piece of writing, historical precedent or other reason to confirm that their bias is correct. This is often done despite large drawdowns in their portfolios.
For example, some traders engage in the same losing strategies for extended periods of time. Something in their brain tells them that if they just hold on long enough, their bias will be justified and they will be rewarded for staying with the status quo. In these instances, traders become emotionally and intellectually attached to losing positions and to a losing market view. This is sometimes referred to as "being married" to a position or a market bias. Even as the losses accumulate, traders will often be unable to stem the losses and will allow them to increase. The trader will justify this escalating loss with any number of psychological defense mechanisms and explanations.
These include statements such as "I took this position for a really good reason, and I know it will work if I just stick to my guns." The reality is that the individual has an extreme desire to be right and, because of inflexibility and despite clearly being wrong, will not cut the position and take the loss. This is a self-perpetuating downward spiral where rigid adherence to the status quo bias results in increasing losses and an even more frantic search to find opinions to justify holding on and accumulating losses.
A particularly malignant form of status quo bias is called decisional escalation. In trading terms, this means that the trader holds so firmly to the status quo concept that he continues to add to a losing position. The spectacular implosion of the Amaranth Hedge Fund is one example of the status quo bias that led to a loss of $4.6 billion over the course of a few days in September 2006. Amaranth's head trader, an experienced and very successful natural gas trader, just kept adding and adding to his losing position in the natural gas futures as he was absolutely convinced that the hurricane season was going to be hideous and the natural gas future spread would rise. As the spreads fell, he kept adding to the position. Despite the fact that the hurricane season was very mild, he could not release his losing positions and, as a result, wiped out the entire Amaranth Group.
The Amaranth disaster was a tragic situation played out on a larger scale than any of us might imagine. However, what many traders do on a small scale is simply a microcosm of it. It was caused by decisional escalation due to inability to abandon the status quo bias in the face of overwhelming evidence that the bias was incorrect.
The takeaway from this discussion is that the status quo bias helps explain the psychological inclinations of market participants to maintain and reinforce a losing strategy instead of having the flexibility to change it in light of all evidence that the strategy is not working. In other words, traders are advised to constantly evaluate their belief systems and the actions they are taking in the markets based on these beliefs. Implicit in this is the ability to take a laser look at yourself, to admit that you were wrong, to take personal responsibility for getting into the situation and to get out immediately.
In all affairs it's a healthy thing now and then to hang a question mark on the things you have long taken for granted…Bertrand Russell
Until Next Time,
Good Trading and Brain On!
Janice Dorn, M.D., Ph.D.
janice@thetradingdoctor.com
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