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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The most important quality for an investor is temperament, not intellect…You need a temperament that derives great pleasure neither from being with the crowd nor against the crowd…Warren Buffett
Decisions about trading and investing bear many similarities to decisions made outside of the markets. Human beings make decisions in the context of numerous societal factors, not in isolation. In this regard, we are functioning less as individuals and more as a social collective.
This is nowhere clearer than in the multimillion dollar marketing industry that targets our brains almost every waking hour of every day. In fact, the marketing industry has become more and more sophisticated as they are putting human beings into brain scanning machines and recording the brain activity in response to marketing messages. This emerging field of neuroscience marketing will grow more powerful in the years ahead, and we will find ourselves desiring and purchasing items for no “logical” reason. Mass psychology and the artificial creation of “absolutely have to have it” can be seen all around you every day. The recent mania over the iPhone is but one example of this phenomenon.
In the realm of trading and investing decisions, the importance of knowing what and how others are thinking is critical for success. Put another way, the social dynamic of herding is evident every day in the markets, and its importance cannot be ignored. In market situations, behavior is motivated by assumptions and perceptions of what other traders and investors are doing. Social psychology, based on collective perceptions of the decisions of other traders, becomes the basis for actions of the individual trader. In this herding process, traders attempt to anticipate and mimic the actions of other traders. Decisions imitate decisions, setting off a kind of self-fulfilling prophecy where more and more traders are making the same decision simply because others are doing the same.
One need look no further than to the momentum that builds in certain stocks during the day. This is not much removed from the message in Herding: Part 1; i.e., “Follow the ant in front of you.” Momentum builds as more and more traders pile into the same position, much like the blind ants that moved in the same circle for several days before a couple of them deviated and broke away from the ant mill.
Numerous scientific studies demonstrate the power of the need to conform to group consensus, particularly in simple and clear-cut situations that involve decision-making. In the markets, the tasks of decision-making are made more difficult because of the instant availability of highly diversified, contradictory and ambiguous information.
What happens to traders when they are bombarded with terabytes of conflicting and confusing information, talking heads on the financial media, the beliefs and thoughts of numerous “authorities” and the constant drumbeat of breaking news? They become uncertain and confused. In other words, the prefrontal (thinking, logical, new) areas of the brain are put into a situation of information overload. The new brain simply cannot process all of this information in the time needed to make critical trading decisions. This is particularly true with novice or inexperienced traders that find themselves tossed from stem to stern as they attempt to “make sense” of the informational barrage. In these situations, the new brain gives up, and the rat (old, primitive, limbic) brain fires into action. The rat brain is the default mechanism—the low road, the quick and easy way that the brain makes decisions in the context of “way too much information.”
In the environment of overload, the brain searches frantically for some rule, some meaning, or something that makes sense. It finds this in the form of so-called “heuristics” or shortcuts. These are formed quickly in the rat brain. The rat brain lies in wait for the new brain to give up and hand it down to the rat brain. It just “feels” that this is the thing to do, and it doesn’t look back. The rat brain reacts when the new brain gives up and defaults to the easy, quick and dirty way. The rat brain says, “Just do it!” The rat brain tricks the trader into thinking that the “big guys” must know more than he does, so he just goes along with them and gets into the position because he absolutely cannot stand it any longer and has to get in.
The “big guys” know this behavior all too well, as they lure the rats brains of the small traders to “get in now” so that that they can exploit them by taking their money. Sometimes the small trader is nimble, gets lucky and catches part of the move. In the majority of cases, the small trader gets trapped and fooled by the rat brain as he or she tries to buy breakouts or sell breakdowns that almost immediately turn around and fail.
Another explanation for herding in the financial markets has to do with the emotions of anticipated regret and fear. It is of interest that these unpleasant feelings of fear and anticipated regret are intensified when they are made in isolation, i.e., not shared with the group. It is easier to be a loser in a group of losers than to be a loser in a group of winners. It is easier to be in fear and regret when others are like-minded—misery loves company.
In this regard, herding may be a reasonable option for those traders that are concerned about their reputations. By failing with others, they put themselves in a position to share the blame and do not have to deal with being ostracized by the group for their individual success in the face of the group's failure. As John Maynard Keynes said, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” The next time you find your rat brain blindly following the herd, you may be well advised to ask yourself if you are following the ant in front of you—and why you are doing it!
I will write in more detail about this aspect of herding because it has great significance for trading decisions and leads us into the controversial and fascinating topic of why more than 50% of all traders may have a deep-seated desire to lose.
The heroes of finance are like beads on a string. When one slips off, the rest follow…Henrik Ibsen
Until Next Time,
Good Trading and (Revitalized) Brain On!
Janice Dorn, M.D., Ph.D.
janice@thetradingdoctor.com
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