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Feature Article

“Last Night, They Got the Elephant" —Fighting a Bias That Kills Profits

by D.R. Barton, Jr.

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One winter night during one of the many German air raids on Moscow in World War II, a distinguished professor of statistics showed up in his local air-raid shelter.

It caused quite a stir because of all the air raid signals of the past (and there were many) he had never appeared there before. "There are 7 million people in Moscow," he used to say. "Why should I expect them to hit me?"

This time, his friends were astonished to see him and asked what had happened to change his mind. "Look," he explained, "there are 7 million people in Moscow and one elephant. Last night they got the elephant."

This story is from Peter Bernstein's delightful book Against the Gods— The Remarkable Story of Risk.  It is easily one of my favorite reads.  It is so well written and tells story after story about how our understanding of risk and uncertainty has been formed over the centuries.  If you have a trading or investing friend who needs a good present for Christmas or Hanukkah, this is a nice pick.

I love this tale because it encapsulates how human beings deal with uncertainty. We may be able to calculate the chance of something happening using statistics and probabilities. We may even understand what the probabilities mean.

But the numbers "don't matter" to us if they get in the way of one of our beliefs.

I know I sound a lot like Van here, and it’s very much on purpose.  Van has taught more people about how to understand and overcome bias and how to work within our belief systems in our own trading and investing than anyone I know.  One of Van’s key tenets (in my own words) is this: Our personal beliefs act as a filter for ALL information that we take in.

Take the statistics professor in the anecdote above. He understood his chance of being killed by a bomb. But a random (and highly memorable) event, the death of the local circus elephant, made him rethink and ultimately change his decision making process, minimizing the importance of the true statistics.

You and I are very likely to make similar mistakes in our trading. And that costs us money.

Let's look at why we ignore profitable trading strategies when certain random and highly memorable events happen. It will help us to keep those strategies in mind, regardless of outside events— and that will give us a greater probability to do the most useful thing.

It Wasn't an Elephant— But It Sure Smelled Like Peanuts

You have a strategy in place that tells you what stock to buy or sell short. The strategy tells you how to get out if you're wrong or hang on when you're right. Through testing or real-time use, you know that the strategy works.

And then it happens—you get a big winner because you followed a tip from your neighbor. Or because you saw a news story on CNBC. Or you held a stock that was a loser, let it run through your stop and then it turned around and made some good money.

The reason why it happened isn't that important. What did happen is that you made nice profits in a trade or investment that wasn't part of your trading plan. This is like Moscow's only elephant being killed, it becomes a random but very memorable event for you.

What happens next is you put the strategy that has been working for you on the back burner. Or you abandon it all together. All of your thoughts are consumed by your own private elephant— that big memorable trade. You want to re-create it, even though there's no evidence that you can.

Three Ways to Combat the Single-Elephant Problem

All the while, your good and faithful strategy (now long forgotten) keeps churning out boring but predictable profits. And you find out that there is no magic formula for monster profits. There was just the one elephant after all.

This is a common problem for traders. Like the Moscow statistics professor, our thoughts and actions become clouded by one event. What can we do to combat this problem? Here are three suggestions that every trader and investor can use avoid being sidetracked by unusual events:

• Have a written plan. If you have no plan, how can you follow it? This is one of the most critical steps for successful investors and traders. But very few people have a plan. And if you have a plan but it is not written down, you don't really have a usable plan. If you need resources for a trading plan, Van’s website is great place to start.  And you can find great help for developing a trading plan (a business plan for your trading and investing) in Chapter 3 of the book Fin. Free. through Electronic Day Trading”.  Don’t let the title throw you off — 70 percent of the book is general information applicable to all types of trading.  And the business planning chapter is quite comprehensive and particularly good.  (I wrote a large part of that chapter and it includes my trading and business plans from early 2000 as models.)

• Understand in advance that distractions will come. Decide what you will do with "special opportunities" before they arise. If you get a credible stock pick that is outside of your strategy, how will you handle it? Include those steps in your written plan. Be sure to include how you will enter and exit such "special cases" and be especially aware of how much capital you are willing to risk on an unproven pick.

• Work to learn your biases. What catches your attention? Does a stock that makes a big win inside your strategy lead you to overtrade that stock? Are you worried that your friends will kid you if you miss out on their hot tip?

I'd love to hear your thoughts and feedback – just send an email to  drbarton “at” vantharp.com.  Until next week…

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured analyst on Fox Business’ Varney & Co. TV show (catch him most Thursdays between 12:30 and 12:45), on Bloomberg Radio Taking Stock and MarketWatch’s Money Life Show. He is also a frequent guest analyst on CNBC’s Closing Bell, WTOP News Radio in Washington, D.C., and has been a guest on China Central Television — America and Canada’s Business News Network. His articles have appeared on SmartMoney.com MarketWatch.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".