Phil Pearlman's Blog

In previous posts, I’ve begun introducing the cognitive theory of noise (CTN), a comprehensive model of market participant experience which will include a prescriptive component that will help traders decrease irrational behaviors and improve profitability.

This is a big project and there will be many more posts that are theoretical in nature. But in this post I would like to skip ahead a bit and offer a prescriptive technique that traders can implement on their own which will promote taking losses quickly.

I have had the opportunity to talk with a number of very successful traders over the years and have found that even while their trading styles and asset classes of choice differ, they all tend to share a few common attributes which separate them from less successful traders and which I believe contribute to a significant portion of their profitability.

In addition, I have traded equities profitably for a number of years myself and have applied certain rational behaviors to my own routine that have served me well.

Getevenitis

One in particular stands out as crucial and so I will begin there. Every winning trader that I know habitually takes losses quickly before they become outsized.

While taking small losses may seem like a simple matter of discipline, there are a number of reasons why this is not the case. I have written about it already here and here but to summarize briefly, holding a losing position tends to spur a set of psychological processes which interrupt the rational choice of realizing the loss.

Once the trader is holding a loser, anxiety increases which spurs the avoidance of loss realization.

Next, the trader will tend to begin rationalizing the position and the loss avoidant behavior with automatic internal statement such as, “this has to come back” or “if I can just get even.”

There are five basic components at play here. These are:

Situational – The trader is in a losing trade

Behavioral – The trader is avoiding loss realization by holding the loser and not selling rationally while the loss is small.

Affective – The trader is experiencing anxiety which increases as the loss increases.

Cognitive – The trader has begun rationalizing the loss with automatic internal statements.

Neuropsychological – The anxiety is accompanied by chemical changes in the central nervous system.

Taken together, these five components form a CTN profile for the disposition effect within the domain of losses or what Shefrin and Statman have also called getevenitis. (I will be writing much more about CTN profiles in upcoming posts)

If you have the tendency to fall into this pattern, you are not alone. It is the normal reaction and a empirically based evidence suggests that the majority of humans in such a situation will tend to respond similarly.

The Clinical Psychological Correlate to Getevenitis

The getevenitis profile I have outlined above is similar in some ways to certain anxiety disorders which result in behavior avoidance. These include simple phobias as well as agoraphobia.

Take for example those who suffer from an intense and irrational fear of bridges, gephyrophobia. They might have a 5 component profile which looks like this:

Situational – The bridge phobic is faced with the thought or prospect of crossing a bridge.

Behavioral – The bridge phobic avoids bridges similar to the way the trader avoids taking the loss.

Affective – The bridge phobic is experiencing anxiety which increases as the bridge approaches.

Cognitive – The bridge phobic rationalizes the fear with automatic internal statements such as, “that bridge might fall while I am on it and I will be killed” and/or “I remember seeing the bridge in Minnesota fall and this one is probably also faulty.”

Neuropsychological – The anxiety is accompanied by chemical changes in the central nervous system.

The treatment might also be similar. Clinical psychologists successfully utilize a treatment for phobics who avoid situations called graded exposure. In exposure, the phobic is guided through a series of exercises in which the exposure to the irrationally feared stimulus is gradually increased until the client is able to approach instead of avoid the it.

Self-Directed Exposure Program for Getevenitis

I will now describe a program that traders can use which might be effective in extinguishing the irrational behavior of holding losses too long.

The rationale here is that if you expose yourself to the action of taking losses quickly, then over the course of the program you will gain the capacity to cut losses fast while you are trading. You will train yourself to make it automatic.

Step One: Imaginal Exposure: Find a quiet and comfortable place and close your eyes. Then, imagine that you are at the screens during the trading day and that you have entered a trade that begins to go against you. Make sure that you take your time during this exercise and visualize every small detail that you can, the ticker, the price of entry, the number of shares, the movement of the stock against you and the feeling you get as this occurs. Then, imagine closing the trade for a small loss quickly.

Repeat this process twice total.

Step Two: Tiny Trade Tiny Loss – Now that you have imagined yourself taking a loss quickly, you will move on to making a set of very small trades and setting very tight stops. Ideally, you will be using a system that charges you by the share rather than by the trade and if you are not you might want to contact your executing broker to see if this is feasible.

Next, pick a stock that you trade and know well and buy a very small increment 1/10 to 1/20 of your normal scale size and buy it. Do not concern yourself with the set up or whether this is a good trade or not. Set an extremely tight mental stop of 10 cents below your entry and a prfit goal of 25 cents.

Then, close the trade down a dime or up .25.

Repeat this several times until taking the loss is almost automatic and extremely easy to do.

Then, repeat it again!

You might be surprised that even though you are not setting the trade, your p/l is not bad. This is because taking small losses quickly is in and of itself rational and limits downside while allowing upside.

Step Three: Repeat Step Two but increase your trade size by 2x. Make sure that before you move on, you are extremely comfortable with taking the small loss and have done so several times.

Step Four: Repeat Step Three but increase your trade size by 2x. Make sure that before you move on, you are extremely comfortable with taking the small loss and have done so several times.

Step Five: Repeat Step One.

Conclusion

You have now gone a long way to training yourself to take losses quickly.

This may take several days to perform the program. Return to your normal trading regiment. You will be well on your way to automatizing the behavior of taking losses quickly and of incorporating it into your routine of trading behaviors which come naturally and with less difficulty than before you started the program.

Every Winter, we come down here to South Florida to gather in and around my parents house in Del Ray with my siblings and their families who are scattered around the country.

Since arriving Thursday afternoon, I’ve sniffed about a bit and even made a few calls inquiring about residential properties specifically in Boca and Miami. Here is my initial impression…

The market is upside down, fubar, but this is no longer news to anyone. The brokers have stopped pretending that all is well which they tend to do during the initial phases of a collapse and have adapted.

Even before asking they offer stories detailing the devastation but then highlighting how well they’ve anticipated and how nimble they have been during the decline. These guys are revisionists just like the false stock market gurus I wrote about last week…

You see it as well in those free rags they publish and distribute on the sidewalk in towns such as Del Ray Beach and Boca Raton. The smarter brokers have simply incorporated the buzz words and framed their marketing in accordance with the environment.

The players have fully attenuated to the clusterfuck.

This seems like a positive sign to me and I’m thinking low ball bids for condos with great views are in order right here and right now…

Most simply formulated, it is a paradox – the paradox of behavior which is at one and the same time self-perpetuating and self-defeating! …Common sense holds that a normal, sensible man, or even a beast to the limits of his intelligence, will weigh and balance the consequences of his acts: if the net effect is favorable, the action producing it will be perpetuated; and if the net effect is unfavorable, the action producing it will be inhibited, abandoned. In neurosis, however, one sees actions which have predominantly unfavorable consequences; yet they persist over a period of months, years, or a lifetime.

-O.H. Mowrer

Perhaps it is purely a coincidence that Prospect Theory: An Analysis of Decision Under Risk and Cognitive Therapy of Depression were both published in 1979 and I am mistakenly attributing some significance to the temporal co-occurrence where none exists.

Afterall, the first offers a critique of expected utility theory and an alternative descriptive model of decision making under risk focusing on loss aversion, framing effects and the like while the second offers a theoretically and empirically derived treatment model for an affective disorder focusing on the centrality of the cognitive aspects of it.

However, upon closer inspection, the timing of the two works, and more importantly, the complementarity may not be so random.

Both possess meta-theoretical roots in the cognitive revolution which emerged during the third quarter of the twentieth century and extended cognitive psychological principles into specific domains of functioning. Both share common underlying assumptions about the way in which humans interact with the world. Both examine ways in which people act in ways which might not be in accordance with their own self interests. And finally, both prospect theory and cognitive therapy spawned new branches of social science with prospect theory playing a critical role in the birth and development of behavioral economics and cognitive therapy marking a milestone in the evolution of cognitive-behavioral and empirically validated theory and treatments of psychological disorders.

Currently, there is no unified comprehensive descriptive theory in behavioral finance that offers a framework within which the various investor behavior phenomena can be assimilated and organized. As well, there is currently no evidence based applied prescriptive model which outlines sets of adaptive change processes that may promote rational investor behavior.

Over the coming months on this blog, I will be outlining a broad descriptive theory of investor experience including an applied prescriptive model which promotes adaptive behavior change. It is an integration of Beck’s clinical cognitive theory and cognitive therapy model from the science of clinical psychology and the investor behavior phenomena described in the behavioral finance literature.

This applied theory which I call the cognitive theory of noise (CTN) offers a model of the structure and path of cognitive functioning that contextualizes the various investor behavior phenomena within a rich and axiomitized theory of human personality. It organizes the interrelationships between cognition, behavior and affect as well as describes how these processes interact with environmental factors.

The CTN also contains a critical prescriptive component which details a procedure for enacting adaptive behavioral change processes among market participants so that they may act in their own best interests more consistently. Finally, this model will be conducive to empirical exploration.

There are two main integrative aspects to the CTN. First, the theoretical model itself may be viewed as an assimilative integration as it seamlessly assimilates investor behavior models from behavioral finance into the framework of clinical cognitive theory. Second, by providing an organizational scheme it allows for a theoretical integration of investor behavior models which are currently somewhat fragmented and only loosely related by common theoretical antecedents including those offered by Daniel Kahneman and Amos Tversky.

When we were in grad school, my wife (then girlfriend) was involved in research where they would use music to induce mood states including sadness and elation over short periods of time. Then, once they had induced mood, they would ask a bunch of questions about cognitions or whatever.

We used to laugh about it because, while the specific pieces of music had been empirically vetted in previous studies, they seemed to us to be poor choices and, whats more, bad music.

So this morning, we are kicking in the kitchen with the brood prepping breakfast and listening to the sublime Elis Regina and genius Tom Jobim and this one in particular has got us feeling pretty good…

Over on StockTwits this morning I am observing a bunch of comments from traders saying that they “sold this rally too soon.” This is a significant collective expression.

There are two important psychological processes occurring here which I will briefly outline for the sake of awareness raising among traders. These are loss aversion and regret.

1. Loss aversion: The two behavioral correlates to loss aversion are appropriately named the disposition effect as they are a universally human experience. These are the tendencies to hold losers too long and sell winners too soon.

The mechanics of these processes work like this. Within the domain of losses, market participants have an innate tendency to deny the figurative and literal realization of losses by avoiding them. They hold. Then, they proceed to cognitively rationalize the behavior with such statements as “well, maybe it will come back” etc. I have written about this here and here.

On the other side, within the domain of gains (when traders have winners) a mirror process occurs which relates to the desire to experience the pleasure of realizing gains. So they take gains too quickly.

I believe that this disposition effect within the domain of gains is in effect here. Whats more, it is accentuated by the environment. That is, stocks have been going down so furiously for so long that the experienced pleasure of realizing a long winner is intensified.

2. Regret – The second significant process occurring here is regret. That is, if someone takes a gain and then that winner continues to move such that the trader missed more gains by selling out, the trader regrets the missed excess profits.

The behavioral correlates to regret in the situation are variable. It will affect some who might spend valuable energy ruing while others will brush it off and move on.

***

Structurally, I think the observation that this is occurring is a minor market positive data point as sellers into strength followed by continued strength will promote more chasers higher.

Further, I will not offer advice for anyone here. You can use the insights any way you would like. Awareness raising is only one small part of adaptively altering behavior and experience in general. Though, in the future on this blog I will have much more to say about initiating adaptive change processes…

(This was originally published on Real Money on 03/06/09 @ 11:32PM EST)

I am reading with interest the comments here on the Real Money Columnist Conversation regarding the psychology of the market now. I think that the tension here is a reflection of the tension among market participants in general.

Traders have been in an increasingly volatile (and stressful) environment since at least February 27th of last year (look up the action on that day) and here is how I see it briefly.

When someone experiences a highly stressful environment for a prolonged period of time many aspects of functioning deteriorate including the congitive (decision making) the behavioral (buying and selling) and the affective (sentiment).

As these areas of functioning veer into the maladptive, participants can get knocked around a lot. This is, in part, why I have been espousing smaller positioning and tighter risk controls for a long time.

The self aware investor here recognizes his/her personal vulnerability.

I will be writing much more about this on my blog over the weekend and will reference it here next week for sure…

Before I get into the heart of a comprehensive model of market participant behavior, I would like to put the concept of prescription into context amid economic theory.

Traditional economists offer normative theories. That is, they model how markets ought to behave in a world where all the participants are rational actors and always behave in accordance with expected utility theory. One need only look at a ten year chart of the SPX to see that these guys are delusional.

Behavioral economists offer descriptive theories. That is, they model how markets really behave and account for irrational market and participant behaviors that are not in accordance with expected utility theory. This is a wonderful step forward from normative models because markets do not occur without the people who make them. Phenomena occur predictably which are not fully rational such as limits to arbitrage (at the market level) and disposition effects (at the participant level).

The shortcoming though of the behavioral economic models is that, while they have assimilated experimental and social psychological models into economic theory, they have neglected clinical psychological models which offer rich and comprehensive models of how humans experience as well as how to effectively promote adaptive change.

They are missing two critical components to the fuller integration of psychology and economics – prescription and personality theory.

Behavioral economics needs to begin integrating prescriptive psychological models into its framework in order to be able to enact adaptive behavioral change in markets and among market participants. I have already outlined why their current attempts to go beyond description are inadequate and in future posts I will begin to outline how this can be accomplished.

In a recent article in the Seattle Times, Teri Cettina interviewed Dan Ariely about his new book entitled Predictably Irrational.

Airely is a behavioral economist at MIT and Duke who has done wonderful research which helps to describe the ways in which people behave irrationally especially where money is involved.

I love this type of research but at the same time have a big problem with assumptions researchers such as Airely ultimately make specifically with regard to prescription.

In the article Airely is quoted thusly,

“Whenever you see the term ‘free,’ consider it a warning to slow down and consider your choice very carefully,” Ariely says. Do the math and always consider what you are giving up when you choose the item attached to something “free.” Usually — but not always — there is a real cost to something touted as “free.”

Such advice, while it might sound great, is preposterous.

People behave irrationally with regard to money for complex and deeply seeded reasons which are immune to rational consideration. If they were not immune, people would not have acted irrationally in the first place! People will not do the math just because you tell them they should…

As I have said before on this blog,

Look there is no simple answer here. During periods like this you will come across armchair shrinks on the cnbc or in the wsj who will spout all kinds of behavioral finance 101 jargon at you and then simply say something like ‘well dont do this’ but i assure u they have no clue what they are talking about… They might as well be saying to the suicidal depressive ‘yo buck up guy snap out of it.’

The bottom line is that while Airely and his bretheren have done a brilliant job describing irrational economic behaviors, they have done a poor job researching and then prescribing solutions. They guys are not experts in the area of human change processes.

So what is really needed is not more descriptive models but solid prescriptive ones.

As we now find ourselves in a period of extreme disequilibrium accompanied by lunatic market participant behavior, I will begin to flesh out on this blog a comprehensive prescriptive model of investor behavior that integrates the descitpive research of Airely and others and the prescriptive work of guys like Aaron Beck.