A smiling trader is a losing trader

6th June 2012

Even if it stops far short of loud cheering, raising both arms in the air and taking a lap of honour around the trading pit, expressing pleasure should cause doubt in those who depend on your skills and will boost the self-esteem of those who are betting against you.

Or at least according to this posting on the PsyFi site. This looks at the practical application of psychology to financial matters including trader/fund manager behaviour – happy people make very bad investors. Success comes from being as miserable as possible.

Confidence comes from success

This is counter-intuitive. Happiness would seem to come from confidence. And confidence from winning ways. This leads to optimism, transmitted to other investors and traders. Victors are imitated and traders need others to follow them so they can close positions profitably.

By contrast, misery and loser seem almost synonymous.  These people are pessimistic and find it hard to influence others to follow in their footsteps to pick up their trades rather than bet against them.

If correct, this is yet another investor paradox. A couple of week a go Mindful Money featured an article suggesting the greater risk equals greater reward equation at the heart of so much investment theory could be challenged. Amongst other points, this stated that fund managers tend to aim at riskier shares.  It gets them noticed if successful and if they fail the fund can brush it under the carpet. And if they did not go for risk, they could easily be replaced by a passive investment strategy.  All this  pushes up the cost of more volatile stocks, and hence depresses the potential reward.

I am depressed but should be elated

Happiness, especially founded in the confidence that the trader is taking fewer risks and making more money, may not make for investment success.

In almost every area of human life – from playing sport to crossing the road – being happy and confident (perhaps over-confident) can lead to mistakes.  Investors and traders tend to over-confidence – if they were not sure of themselves, they would leave their money in the local bank account. Evidence in Psy Fi essay Overconfidence and Over Optimism points to investors over-trading. And the more confident they are, the more they over-trade.

Just when trading becomes over-trading is admittedly impossible to define.  But they more people trade, the less they gain. This is because some one who is happy because they have made a successful deal, goes on to trade again. If that one fails, they try for a third time. The frequent trader is almost certainly a cheerful person as depressives tend not to go in for this activity.  However, the more trades that are made, the more likely the result will revert to the average of all trades.

But each trade costs in transaction fees. Someone with £10,000 in a market where the average gain over time is £500 who trades 10 times may run up £50 in expenses, leaving £450.  The really elated trader will on 20 deals will still end up with the £500 but incur £100 in costs, reducing profits to £400.

It's possible this is a problem of self-selection, where it's mainly over-optimistic people who over-trade. However, this isn't just a problem in investment. Humans seem, by and large, to be habitually overconfident on most positive traits and, according to this research by Williams and Gilovich, genuinely believe their flattering self-assessments.

Trading is a zero-sum game (ignoring expenses).  One of the unanswered questions in the recent JP Morgan write-offs – the investment bank may have lost as much as $7bn in trades that were supposed to suppress risk – is where the money went to.  Which were the banks and trading institutions on the other side of these trades?  If JP Morgan lost, then who gained? 

Whether the loan trader or the massive investment bank,  unsuccessful trading or over-trading may  be caused by reference group neglect or egocentrism. People consider their own abilities, they create spreadsheets which show they are on the way to a fortune but forget, in their happiness and over-confidence, that the competition may be just as good, if not better (or with more going such as first-mover advantage).  Trading is an especially difficult environment where every player has the self-belief of an investment demi-god.

An investigation by academics Jessica Kennedy, Cameron Anderson and Don Moore in Social Reactions to Overconfidence. Do the Costs of Overconfidence Outweigh the Benefits suggests  overconfidence provides social benefits, such as higher status in groups. The confident fund manager or trader has a façade to keep up otherwise there would be an adverse reaction. No one trusts a nervous investment professional.  On the other hand, we are attracted towards the confident – we love winners and wish to emulate them whether in the investment, sporting or showbiz arenas.

When Netherlands-based Guy Kaplanski and colleagues looked at the relationship between happiness and investing they found:

"The happier the subject the more optimistic she is with regard to the stock market. Specifically, we find that the better the general mood of the individual, the better the perceived weather, and the better the results of the individual's favorite soccer team in the days close to the questionnaire completion date, the higher the predicted expected return in the U.S. market as we
ll as in the domestic Dutch stock market."

The Psy Fi blog says: "The idea that emotions are related to market booms is one that's been around a while, but it's now been specifically investigated in Bubbling With Excitement, by Shengle Lin, Terrance Odean and Eduardo Andrade. They hypothesised that if emotions are linked to investing then they might be able to induce over-trading by putting respondents in a good mood. Their results support the theory, showing that the magnitude and amplitude of bubbles is greater when prior to trading traders experience high intensity, positive emotions than when they experience low intensity, neutral emotions, or high intensity, negative emotions. Thus rapidly rising prices may trigger the very emotions that lead to larger asset pricing bubbles." 

These positive feelings lead to more buying activity which, in turn, pushes up prices inflating bubbles – a situation of "mass delusional positive feedback".  A look at the dotcom boom and bust in 1999-2000 provides all the evidence needed.  Happy investors throw money at the latest trend. Depressed investors do not trust it.

 

More on Mindful Money:

Risk and reward don't go hand in hand

Upside down economics – morality before greed

Economics and the brain: how people really make decisions in turbulent times

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