The Hindu Business Line : Getting inside the mind of the traders

To understand markets, try out, Traders, written by Mark Fenton-O'Creevy, Nigel Nicholson, Emma Soane and Paul Willman, from Oxford (www.oup.com).

The book is based on a study, over three years, of more than a hundred denizens of financial markets, and their psychological and social influences.

A chapter on `Trader Psychology' explains that a well-known trap in trading environments is the reluctance to take the plunge and decide, ever waiting for sufficient information.

"Perfectionists who are unable to be swiftly decisive cannot make money, and cannot survive. As the saying goes, `the best is the enemy of the good.'"

Market Traps

Decisions, therefore, have to satisfice, "by letting a `good enough' threshold trigger choice". Experience shows as the lowering of this threshold. "One strategy is for managers to help them take the perspective of a funnelled focus."

Another trap is `base-rate insensitivity'. This shows when you are "over-impressed by percentages while overlooking absolute values." A different pothole in the financial world is `mistaken frequency estimate'.

This is `a dysfunctional aspect of our sensitivities,' explain the authors. "We tend to be very poor at evaluating frequencies. Rare events not only stand out, but they are often subjectively perceived to be more frequent than they actually are, especially negative events and major risks."

Influence of prior expectations is one more hurdle. "The starving man is more prone to food mirages than the person with the sated appetite." Similarly, trained scientists "are highly prone to seeking evidence that is in line with their cherished theories." Traders too may suffer from such a problem.

"If I had a new suit on a bad trading day, I wouldn't wear it again, even if it was brand new," reads one of the trader quotes cited in the book. "It is disturbing, but only human, to find traders as full of superstitions as the rest of us, but at the same time most are aware of this irrationality enough to engage in some healthy discounting."A dangerous challenge is not to chase losses.

"The trader who starts to pile up losses in an environment where the bad news keeps coming may be apt to feel loss of control."

The authors explain: "If a trader believes, as some do, that all winning trades are due to their good judgment and all losing trades are due to market factors, then they are only a whisker away from megalomania (on a winning streak) and depression (on a losing run)."

Watch out for ego-involvement, "the tendency to identify with one's actions". Traders who fall a victim to this can be "obsessive, emotionally reactive, and often living unbalanced lives because of their inability to shut off at the end of the day, weekends and vacations." Such people may not be bad traders; yet, they run a greater risk of "persisting overlong in their engagements with situations where early exit would be the best strategy."

Problems aren't over with decision-making. Many problems arise in the aftermath, say the authors.

"Reactions to outcomes may defeat rationality — storing up a legacy of unhelpful orientations to be carried forward into the next decision." Thus `illusion of control' is caused when one makes "a favourable interpretation of the outcome". Not a case of being wise after the event, you'd agree! "Hindsight bias is part of the price we pay for the benefit of reconstructive memory," elaborate the authors. "From here it is a short step to rationalisation — the tendency to re-evaluate negative outcomes in a positive light."

Becoming a trader demands `emotional self-management', such as what an equities trader talks about in this snatch: "Staying emotionally calm all the time is the hardest. It's not so much making or losing money because that's more clinical. It's the constant staying calm and emotionally neutral when people are shouting, yelling, screaming and asking stupid questions."

Though trading is a complex environment, there is little training, rues the conclusion. Disappointingly, "Managers emerge from the trading cadre with at best tacit knowledge about managing people under stress."

The authors, therefore, see a role for "some form of accreditation on the part of those responsible for traders, to ensure that they at least understand the existence of behavioural implications of heuristics and biases."

Helpful clues to understand the trading mind!

BookValue@TheHindu.co.in