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TAMING THE TURTLE MIND
Part Two
by Curtis Faith
Excerpted from the Newly Released Way of the Turtle
In part of this excerpt from the excellent new book by Curtis Faith, we detailed some of the most powerful misperceptions that affect trading and prices. If you missed part one, click here.
This week we'll look at each cognitive bias in greater detail.
People who are affected by loss aversion have an absolute preference for avoiding losses rather than acquiring gains. For most people, losing $100 is not the same as not winning $100. However, from a rational point of view the two things are the same: They both represent a net negative change of $100. Research has suggested that losses can have as much as twice the psychological power of gains. In terms of trading, loss aversion affects one�s ability to follow mechanical trading systems because the losses incurred in following a system are felt more strongly than are the potential winnings from using that system. People feel the pain of losing much more strongly when they follow rules than they do when they incur the same losses from a missed opportunity or by ignoring the rules of the system. Thus, a $10,000 loss is felt as strongly as a $20,000 missed opportunity. In business, sunk costs are costs that already have been incurred and cannot be recovered. For example, an investment that already has been spent on research for a new technology is a sunk cost. The sunk cost effect is the tendency for people to consider the amount of money that already has been spent�the sunk costs�when making decisions.
Say the ACME Company has spent $100 million developing a particular technology for building laptop displays. Now suppose that after spending this money it becomes obvious that an alternative technology is much better and more likely to produce the desired results in the required time frame. A purely rational approach would be to weigh the future costs of adopting the new technology against the future expense of continuing to use the developed technology and then make a decision solely on the basis of future benefits and expenditures, completely disregarding the amount of money that already has been spent.
However, the sunk cost effect causes those who make this decision to consider the amount of money previously spent and view it as a waste of $100 million if a different technology is used. They may choose to continue with the original decision even if it means spending two or three times as much in the future to build the laptop displays. The sunk cost effect leads to bad decision making that often is heightened in group situations.
How does this phenomenon influence trading? Consider the typical new trader who initiated a trade with the expectation of winning $2,000. At the time the trade first was entered, he decided that he would exit the position if the price dropped to the point where a $1,000 loss would be incurred. After a few days, the trade�s position is at a $500 loss. A few more days pass and the loss grows to over $1,000: More than 10 percent of the trading account. The value of that account has dropped from $10,000 to less than $9,000.
This also happens to be the point where the trader previously decided to exit.
Consider how cognitive biases might affect the decision whether to keep true to the prior commitment to get out at a $1,000 loss or to keep holding the position. Loss aversion makes it extremely painful for the trader to consider exiting the position because that would make the loss permanent. As long as he does not exit, he believes there is a chance that the market will come back and turn the loss into a win. The sunk cost effect makes the decision not one of deciding what the market is likely to do in the future but one of finding ways to avoid wasting the $1,000 that already has been spent on the trade. So, the new trader continues to hold the position not because of what he believes the market is likely to do but because he does not want to take a loss and waste that $1,000. What will he do when the price drops even more and the loss increases to $2,000? Rational thought dictates that he will exit. Regardless of his earlier assumption about the market, the market clearly is telling him that he was wrong, since it is far past the point at which he originally decided to exit. Unfortunately, both biases are even stronger at this point. The loss he wishes to avoid is now larger and even more painful to consider. For many, this kind of behavior will continue until the trader loses all his money or finally panics and exits with a loss of 30 to 50 percent of his account, perhaps three to five times what he had planned.
I worked in Silicon Valley during the height of the Internet craze and had many friends who were engineers and marketers for hightech companies. Several of them were worth millions from stock options on companies that recently had gone public. They watched the prices go up day after day during late 1999 and early 2000. As prices started to drop in 2000, I asked many of them when they were going to sell their stock. The reply was inevitably something along the lines of the following: �I�ll sell if it gets back up to $X,� a price that was significantly higher than the level at which the market was when I asked. Almost every single one of my friends who was in this position watched the price of his or her stock drop to a tenth or even a hundredth of its previous value without selling the shares. The lower it dropped, the easier it was for them to justify waiting. �Well I�ve already lost $2 million. What�s a few more hundred thousand?� they would say.
The disposition effect is the tendency for investors to sell shares whose price is increasing and keep shares that have dropped in value. Some say that this effect is related to the sunk cost effect since both provide evidence of people not wanting to face the reality of a prior decision that has not worked out. Similarly, the tendency to lock in winning trades stems from the desire to avoid losing the winnings. For traders who exhibit this tendency, it becomes very difficult to make up for large losses when winning trades are prematurely cut short of their potential.
Outcome bias is the propensity to judge a decision by its outcome rather than by the quality of the decision at the time it was made. Much of life is uncertain. There are no right answers to many of the questions that involve risk and uncertainty. For this reason, a person sometimes will make a decision that he considers rational and that appears to be correct, but as a result of unforeseen and unforeseeable circumstances that decision will not lead to the desired outcome. Outcome bias causes people to put too much emphasis on what actually occurred rather than on the quality of the decision itself.
In trading, even a correct approach can result in losing trades, perhaps a few in a row. These losses can cause traders to doubt themselves and their decision process, and they then evaluate the approach they have been using negatively because the outcome of that approach has been negative. The next bias makes this problem particularly acute.
Recency bias is the tendency for individuals to place greater importance on more recent data and experience. A trade that was made yesterday weighs more heavily than do trades from last week or last year. Two months of losing trades can count as much as or more than the six months of winning trades that happened previously. Thus, the outcome of a series of recent trades will cause most traders to doubt their method and decision-making process. Anchoring is the tendency for people to rely too heavily on readily available information when making a decision involving uncertainty. They may anchor a recent price and make decisions on the basis of how the current price relates to that price. This is one of the reasons my friends had such difficulty selling their stocks: They were anchoring on the recent highs and comparing the current price with those highs. After they made that comparison, the current price always looked too low.
The observation that people often believe things because many other people believe them is known as the bandwagon effect or the herd effect. The bandwagon effect is partially responsible for the seemingly unstoppable increase in prices at the end of a price bubble.
People who fall under the spell of the law of small numbers believe that a small sample closely resembles the population from which it is drawn. The term is taken from the statistical law of large numbers, which shows that a large sample drawn from a population does closely resemble the population from which it is taken.
This law is the basis of all polling. A sample of 500 taken randomly from a larger population can give very good estimations for a population of 200 million or more people. In contrast, very small samples do not reveal much about the underlying population. For example, if a trading strategy works four times out of a test of six times, most people would say the strategy is a good one, whereas statistical evidence indicates that there is not enough information to draw that conclusion with any certainty. If a mutual fund manager outperforms the indexes three years in a row, he is considered a hero. Unfortunately, a few years of performance says very little about what the long-term expectations might be. Belief in the law of small numbers causes people to gain and lose too much confidence too quickly. When combined with the recency effect and outcome bias, it often results in traders abandoning valid approaches just before those approaches start working again. Cognitive biases have a profound effect on traders because if a trader is not influenced by them, almost every bias creates opportunities to make money. In the following chapters, as specific aspects of the Turtle Way are explored, you will see how avoiding these biases can provide you with a significant advantage in trading.
About the book: Way of the Turtle takes a never-before-seen look at the legendary Turtle Traders and the famous experiment that made them millions. Curtis Faith, the most successful member of this elite group, breaks the silence to reveal the rules, timing, risks, rewards, and secrets to his biggest trades and 100 percent annual returns. Sharing behind-the-scenes insights and step-by-step techniques, Faith shows how you can use the Turtle Way to achieve enormous profits-whatever your skill level. Way of the Turtle is available at Amazon.com.
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Top Notch Internet Resources
Part VII
More Online No-Cost Charting
By D.R. Barton, Jr.
First of all, thanks for all your useful links and e-mails! If you haven�t sent your favorite sites in yet, please see my e-mail address at the bottom of the article.
An overview of online no-cost charting:
The good news: there are loads of excellent online charting sites available.
The bad news: there is no one site that is the best for everything.
The basic problem with online charting is that there is no site that does futures and stocks comprehensively. We talked about the reigning champ for no-cost online futures charting � www.futuresource.com. The lack of suitable competition made that an easy choice. The choice among stock charting sites is not so straight forward.
Last week, we looked at charts from Yahoo! and summarized them as follows: ��a very strong package with scads of data, good readability, and useful if limited technical analysis tools�.
Today we�ll take a look at Google Finance, and Barchart.com and move on to Bigcharts.com next week.
Google Finance as a site has a couple of nice features, including Google�s trademark uncluttered look and a neat sector summary at the bottom right of their home page. This same minimalist approach does not translate well into their charting package, however. For a quick glance, they�re okay, but for anything more in-depth than that the minimalism becomes a true hindrance.
With Google�s charts, you can only get line charts (not OHLC or candlestick options). You have no resizing options � one size fits all. Most disappointingly, there are no technical indicators available. Google does have a few useful features on their charts worth noting.
The most unique feature is extended hours charts. The U.S. equity market day session is from 9:30 a.m. EST until 4:00. But trading really starts at 8:00 a.m. and goes until 6:30 p.m. and on some exchanges up to 8:00 p.m. in what is known as extended hours trading. Google gives you the options of seeing this data; a feature I haven�t found in other online charting packages. This feature can be useful for tracking what happens during an earnings announcement or other news that happens before or after normal trading hours. And finally, Google gives up to 40 years of historical data, making it useful for long-term research.
A site that several readers mentioned in their e-mails is barchart.com. (Don�t make this plural � as in barcharts � or you�ll get a site offering laminated reference guides for academic studies. Go figure!). Barchart.com does have some really interesting features � including performance results for following simple systems such as moving average crosses for individual stocks. To find this feature in a no-cost site is interesting enough, that I�ll be writing an article dedicated to this .
But as a charting site, Barchart.com has some serious user interface issues. It takes multiple clicks to even get to a basic chart. Adding indicators requires that you go to a completely different page to add the indicators and then come back to the chart. With that said, they do have one of the better portfolios of indicators available for a no-cost site. If they overhauled their user interface to put all of the controls on one page, this would be a formidable charting site. As it stands, it is a site that is very rough around the edges but may be worth the hassle to get at the treasure-trove of info lurking deep beneath the surface.
Next week we'll keep working on the no-cost online charting tools, looking at one of the front-runners at BigCharts.com. Keep sending in your favorite sites to [email protected] . And let me know if you�ve found this discussion useful! Until next week�
Great Trading!
D. R.
About D. R. Barton: 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 where he is one of the most widely read and followed traders and analysts in the world.
He is a regularly featured guest analyst on both Report on Business TV, and WTOP News Radio in Washington, D. C., and has been a guest analyst on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine.
BETA TESTERS
Thank you to all of the readers who would like to be a part of the beta test. We hope to get the first round of testing out in a couple of weeks.
Birthday Bash
by Melita Hunt
This week I thought that I would give an update on something fun that we recently did here at the Van Tharp Institute.
Just over a month ago Van and his niece Nanthini came to our offices to talk about holding a surprise party for Kala�s 50th birthday (Van�s wife). Initially it was suggested that we have it at their home (not much surprise about that), then possibly at our offices (not particularly festive and a catering nightmare). Ultimately we settled on a wine lounge downtown called Mosaic that Kala really likes. And the planning began.
Initially, Van suggested a small gathering, but thankfully he decided to leave the organizing up to his niece and the staff because, being the introvert that he is, it was clear that what he regards as a �birthday bash� was not necessarily in alignment with what an extrovert would regard as a �birthday bash� � and Kala and I are both very clearly extroverts. We love to talk and be surrounded by people so we decided to make it a wee bit bigger than an intimate gathering.
The staff had a great time preparing the festivities, although there were a few nervous moments whenever Kala came to our office. She�s a pretty sharp lady so we really had to be on the ball to ensure that all of our stories matched and that no-one slipped up or happened to be working on invitations, photos etc...when she was around. I think keeping the secret was just as much fun as the event itself.
So the invites went out and a week before the party, I casually asked her if she wanted to attend a VIP art exhibition and opening of Mosaic�s new lounge area (called the Kasbah) on Friday night. She was all for it and asked if I could get extra tickets for family members who were in town for both her birthday and Nanthini�s graduation. So far, so good. Nanthini made some amazing tickets that really looked like the real deal. And we were set.
Everyone arrived and was hidden away by 7pm � which was the time that Van and Nanthini were planning to leave their house. At 7:30 they arrived and although she walked in tentatively, she was really surprised at the number of people that were there and that many of them had come from far and wide to celebrate her birthday.
After the fact, we were to learn that an invitation had somehow been returned to her home address on the day of the party, but she certainly didn�t know who was attending, how many would attend or that we had been hiding people (including Van�s son Robert) at our homes during the week. The night was amazing and she was certainly the belle of the ball.
SO, no particular lesson this week, other than its fun to have fun.
If you�d like to take a look at some of the birthday bash photos and join in the fun, just click this link Kala's Birthday Photos.
You can contact Melita at [email protected]
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