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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Markets are constantly in a state of uncertainty and flux. Money is made by discounting the obvious and betting on the unexpected…George Soros
Yesterday, I was standing at the counter of a convenience store waiting to pay for one of the local newspapers. Standing next to me was a thin, shabbily dressed woman who looked to be in the range of 80 years old. She had holes in both shoes, and her face was deeply tanned and wrinkled. It was pretty clear that she was either homeless or living far below the poverty level. She stood motionless, not looking at anyone, clutching a crinkled dollar bill in her shaking, outstretched hand.
I thought she might want quarters for a bus ride, so I asked her quietly if she needed change. She did not look at me, but rather continued to look straight ahead and began to wave the dollar bill at the clerk. He knew exactly what to do. He took the dollar, went over to the Quick Pick machine and placed a lottery ticket into her shaking hand. She held the ticket in her trembling hand, raised it slowly to her lips and kissed it. Then, she turned, left the store and disappeared into the crowded streets.
Traditional economic theory says that it is complete nonsense to buy a lottery ticket. The expected utility (a fancy economic term for value) on a lottery ticket is 40¢ for every $1.00 spent. This means that the average lottery purchaser loses 60¢ on every dollar.
Despite this, millions of people buy lottery tickets every week. Additionally, they go to casinos and day-trade stocks, options, currencies and futures. Unlike the lottery and the casinos where the “house” almost always wins, it is possible to make money day-trading. Many do it and do it well for years. The majority, unfortunately, do not do well day-trading. The exceptions are those that you hear about. Such people are highly trained and coached, and have rigorous trading plans and the courage to execute them. It is critical to study the habits of winning traders, because there are certain common denominators that winners have. I will discuss these qualities in more detail in later Trading Wisdoms.
Today, I want to focus on why people keep doing the same thing over and over again (buying lottery tickets, putting money into casinos, day-trading) in the face of consistent losses. Put in terms of behavioral neurofinance, the question is why people decide to pursue negative-expected-value gambles.
In order to understand this widespread phenomenon and to apply it to yourself, it is necessary to look at the way that the brain makes decisions. Most decisions for which potential outcome sizes and probability are known are made according to what are called “expected value calculations.” Such calculations are made by the analytical (new, cerebral cortex) part of the brain and involve mathematical outcomes such as position-sizing, probabilities and time frames for potential winners and losers. This is an analytical process that involves almost no emotion (no participation from the rat brain) and is framed quantitatively. In other words, it is mathematical with little intuition involved. Despite the hype about so-called quantitative systems and the new breed of “quant traders,” such calculations and formulas must be used with caution.
The reason for this is that the majority of investing and trading decisions produce uncertain outcomes of unknown size. When we are dealing with a complex adaptive system like the financial markets, we are always in the area of decision-making under conditions of uncertainty. Quant models can do well, but what happens when everyone is trading with the same model? You have just seen it in the behavior of the markets over the past two weeks. A one-model system, where everyone is leaning the same way, is an example of herding behavior. It just takes one of these models to diverge from the herd to begin a positive feedback cascade that sends markets tumbling.
Let’s get practical and down to you, the individual trader. Most people trade stocks because they like the markets, and the markets present unlimited opportunities anytime they are open. Traders enjoy predicting, strategizing, playing, discussing the markets with other traders and the emotional thrill of trading. Now, here is the part that the traditional economists miss: If a person likes something or likes to do something, regardless of mathematical outcomes, the expected utility is more related to emotions than to quantitative analysis. In other words, the expected utility is qualitative. Most traders and investors make choices based on how they feel rather than on what they have calculated.
The takeaway from this truncated discussion of utility is this: The reason that so many traders lose in the markets is that they make systematic errors in outcome probability and size estimation. Their expectations are too high and are biased by the presence of strong emotional inputs. In simpler terms, no matter how calculated and mathematical things look on paper, the ultimate decision is emotional. The rat brain takes over once people are in the realm of money. That is why old women living in poverty buy lottery tickets, why people lose millions of dollars a day at casinos, and why traders are fearful when they should be greedy. It’s all hardwired in the brain.
It is principally at games of chance that a multitude of illusions support hope and sustain it against unfavorable chances…Simon Laplace
Until Next Time,
Good Trading and Brain On!
Janice Dorn, M.D., Ph.D.
janice@thetradingdoctor.com
P.S. Every week, I send you a Trading Wisdom designed to make you better, smarter, more balanced traders. Today, I want to ask you, “How are you doing?” Please join me and your fellow traders at the message board and tell us which of my Trading Wisdoms have been most helpful in getting you on a path to profitable trading. How have you used my methods and insights to make big money or avoid huge pitfalls? Tell me what you think, and your favorite Trading Wisdom may be featured in my upcoming book! Stop by today!
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