Cognitive bias

In behavioural finance, they talk about cognitive bias. These are reasons why normally smart people do daft things when investing/trading, etc. One of these that I keep falling for is called, "the disposition effect". This is where you try to lock in gains but let losses run. I'm okay at letting gains run, so thats half the battle but I still let losses run, rather than cut them off at my planned stop loss point.

There are several other cognitive biases which are quite interesting. Amongst these are:

• Loss aversion - where we'll do more to avoid loss than make a gain (see http://bettrading100to100000.blogspot.com/2007/06/why-do-we-act-like-idiots.html)


• The sunk cost effect - money spent is given more value than future money


• Disposition effect (just mentioned)


• Outcome bias - ons by outcome rather than quality of decision at time it was made


• Recency bias - where recent information/experience is weighted more strongly than earlier infomation/experience.


• Anchoring - Relying too heavily on readilly available information


• The band wagon effect - Believing things because many other people do.

If anyone is interested in these, I can go into more detail in a future post.

A good book that covers these is:

Recommended Reading

I thought I'd set up a list of books that I have read and can recommend. I'll keep this page updated and have a link from a perma-link to it.


Way of the Turtle


A book I keep referring to. This book gives a great insight into the world of trading by one of a select group of millionaire traders. Although it is focussed on the financial markets, e.g. options trading, futures trading, etc, there is so much that can be applied to bet trading.
The sections on Behavioural finance and the work of Kahnman and Tversky are worth reading. The book covers the methods the turtle group used to make millions. The methods are simple and seem mainly concerned with building mechanical trading systems that remove the emotional side. Having just lost pretty heavilly (in terms of proportion of bank) due to these very issues (not being mechanical enough), I can only relate to it more.

The New Market Wizards

This was the book that lead me to the "Way of the Turtle". In this book, author Jack Schwager, interviews some of America's top traders. Not just those who have brought in the most money, but those who have performed consistently over the years (see next book, to discover why just basing on most money is not a valid reason).
A really interesting book and one that hammers home the same points about getting away from emotional trading and escaping from the herd mentality.

Fooled by Randomness

This was a real eye opener to me. The premise of this book is that we (including many mathematicians, statisticians, business people, me, you, pretty much most people), just don't really understand randomness and make wrong assumptions, that can have real bad repercussions. The author talks a lot about traders (as this is also his background) who after making a lot of money "blew up" and lost all they had made and lots more due to what the deemed were unprobable events. Written in a very conversational tone and with personality. An eye opener and a must read for anyone involved in an area that involves randomness.

Deflated bank

Bank: £62

I'm not a happy bunny. My bank is down to nearly half. What happened?

I took two £19 losses and made some little gains and a little loss (which could have been nasty, but I turned it around, just).

My first trade looked very promising. I got in early on an obvious trend. I was quite pleased with myself and was letting it run, when the moment of horror struck. I hadn't checked the software I was using properly before starting and had left on some automatic settings. Each of the backs I had put on had been getting automatically generated lays put on. I checked the matched/unmatched queues and saw several unmatched entries. I was rather exposed and after kicking myself for not paying enough attention I had to go full out to avoid a bad loss. I pulled it back but still made a small loss.

Next up, I did a couple of trades and made some small gains, then I had another bad one. I had put on a lay and was watching the price slowly rising, ready to get out if it turned against me when suddenly, in the blink of an eye, the price dropped a huge amount, at least ten ticks and I was suddenly losing. I sat in shock a couple of seconds, double taking the numbers I was seeing. Time was running out and I needed to take a fair loss and get on, but I didn't. I fell into the trap again. I sat there thinking it'll turn back. It didn't. I ended up letting the bet run and I lost. Stupid. £19 down on that. Okay, not a huge sum, but in proportion to the bank, it is almost 20%.

The final loss was again me getting myself in trouble by not understanding the software. I was making multiple trades on a race and had a few quid in the green. I allowed myself 3 ticks stop loss, which I was handling manually (mistake, I will do this automatically in future). The price moved against me and I hesitated, letting it roll passed my self imposed stop loss trigger (always stick to your rules. Lesson hopefully learnt (again)). After the price moved around, going up and down, with my heart rate matching it, it finally returned to my stop loss value and I tried to get out. I thought I had done it but when I looked at the stake, it was only half what it should have been. I had left the auto hedge fature on (changes the stakes so that you automatically get green ups) whilst having an unmatched back in the queue from earlier. It used the unmatched amount as part of its stake calculation. The price had then moved on again and I was still exposed. For some reason, when I make a silly mistake like this I act like the system no longer applies and once again I let the bet run and I lost.

Lots of lessons to take on board. One big one is that I can't always be trusted to stick to the rules I have set myself. How weird is that. When it comes down to it, in certain circumstances, I feel "above the law"! I hope now that I have noticed this, I can fix it. It's funny but all these reactions are covered in some of the books I have recently read, so it's not like it is new stuff (behavioural finance, kahneman/tversky, etc). It's just different reading and understanding it and then doing it. I hope this lesson is finally learnt. I think I will try and mechanise the process more, using software driven stop losses etc.

Too much emotion!

"Price movement is a function of the collective perception of buyers and sellers in a market", according to Curtis Faith, in "Way of the Turtle". This definition says to me that the most important aspect of trading is an understanding of the psychology of buyers and sellers. He goes on to say, "Markets are comprised of individuals all with hopes, fears and foibles." and suggests that the trader's edge comes in "seeking opportunities that arise from these human emotions".

The subject of Behavioural Finance is a study of this. The subject is too big to cover in a post but I hope, in this one, to go over some of the factors that affect betting and laying decisions.

People tend to drive their decisions by emotions rather than rational reason. To back this up, an experiment was documented, whereby a man was found, who having had a stroke that damaged the areas of his brain that generated emotion, (so that all his decisions would be rational, reasoned and conscious), was found to be unable to make even a basic decision, constantly too-ing and fro-ing between alternatives. It turns out that emotions are the short cut that help us make quick decisions (and then justify, after the fact, with our rational mind (remember, hindsight has 20:20 vision!)).

Part of the reason people lose money when trading is due to these emotional short cuts, e.g.

• People are prone to making systematic errors in circumstances of uncertainty
  
• Under duress, people make poor assessment of risk and event probability


• People rarely make completely rational decisions
  

Some examples of the emotions we encounter when making trading decisions:

• Hope - "I hope it goes up after I buy"


• Fear - "I can't take another loss, I'll sit this one out"


• Greed - "I'm making loads, I'll double my position"


• Despair - "The market keeps moving against me, whatever I do!"

Underneath these emotions are what are called cognitive biases. These are beliefs and attitudes that also lead us to make bad trading decisions. I'll talk about these in a future post.

Just like "Trading Places"

I keep referring back to "The Way of the Turtle: The Secret Methods That Turned Ordinary People into Legendary Traders" book, but it has really got me excited.

I think I need to explain why it is called, "The way of the turtle". Anyone who remembers the movie, "Trading Places", with Eddie Murphy and Dan Ackroyd will remember that the story started when two businessmen made a wager about whether business success was an inborn talent or could be taught. The turtle story is similar.

Two trading gurus, Richard Dennis and William Eckhardt, were arguing about whether trading was a natural talent or whether it could be taught. To find out they (guess what?, that's right!) had a wager. They would put out adverts looking for a group of 23 people that they would interview and choose from to be their trainee traders. They would then give them 2 weeks training and then let them trade using their money. The group were known as the turtles and they were very successful, in fact legendary.

In the book "The New Market Wizards: Conversations with America's Top Traders", there is a chapter called, "The Silence of the Turtles". One of the turtles is interviewed but he says very little. All the turtles were under secrecy and non-disclosure contracts and so had to keep quiet.
With the contract period over, Curtis Faith, one of the most successful and youngest (19 at the time) turtles, now explains their methods and philosophy.

It is really worth a read, just for the parts about Behavioural Finance.

The differences between financial markets trading and bet trading are not so great, other than the amounts of money on the table and so reading this book really is a benefit.