The Psychology of Trading

by Brett N Steenbarger

  Chapter Two

  The Student Who Wouldn't Study

  Overlearned behaviors become automatic: the source of our freedom—and our slavery.

  Once we find solutions, our challenge is to enact them consistently. Many of us know what is right to do in life—be good to our spouse, be patient with the children, exercise regularly, eat in a healthy way—but we fail to sustain our good intentions. Trading is the epitome of purposive activity; successful trading is planful trading. In this chapter, we will explore the topic of purpose and some of the factors that will help you become a more-directed, intentional human being. By learning to sustain purpose—expanding your free will—you also cultivate the ability to formulate and to follow successful trading plans. The best trading system, however, like the best exercise program, will not help you if you cannot consistently follow it.

  KEN, THE FAILURE

  I entered the office early on a Monday morning, large coffee already in hand. I knew it was going to be a full day of counseling. You've probably already discerned that mine is not an ordinary therapy practice. I primarily deliver counseling services to medical students, resident physicians, nurses, graduate students, and a variety of other health professionals. Most of these are high-achieving, bright individuals whose positions in the market of life could be described as long on stress and short on time. Working on the hospital floors for 12 hours a day and then studying at night doesn't leave time for lengthy psychoanalysis. That is why students come to me as a "brief therapist." People in busy professions appreciate techniques that accelerate psychological change.

  Brief therapy, to be sure, isn't for everyone. Some people have chronic emotional problems that require ongoing medical and psychological treatment. The majority of productive people in the working world, however, are not chronically debilitated, even if they do find themselves reliving destructive patterns. Such people have considerable intellectual and emotional resources and, indeed, generally function at a very high level. It is not in jest that I describe my work as "therapy for the mentally well." If you think of people as cars, I am less a repair shop than a performance specialist, helping people tweak those last bits of horsepower and foot-pounds of torque from their factory engines. And in high-risk/high-reward environments that absorb a great deal of time and energy—like medicine or trading—there is a premium placed on every incremental bit of emotional performance.

  As I scanned my Monday schedule, I noticed that Ken was my first meeting of the day. I took a long, deep breath. I knew very well that this would not be an easy meeting.

  Ken first came to me after he failed the first two pathology examinations. He was petrified at the thought of failing the course, for this would prevent him from moving on to the clinical portion of his medical education. It would also damage his chances of landing a residency in a competitive medical specialty. The remaining two exams, Ken knew, were going to make or break him. He needed every ounce of motivation and concentration he could muster.

  But he could muster none.

  After studying his heart out—to the point of pulling multiple all-nighters—Ken only had failing grades to show for his efforts. To his complete befuddlement and frustration, he studied the same material as other students and yet scored significantly lower. Even more maddening, he consistently achieved high scores when he took practice exams, only to find the material flying out of his head during the actual test. He was so upset by his lack of success on the first test that he resolved to do whatever it took to pass the course. He spent his evenings, nights, and weekends in nonstop study, losing both sleep and weight in the process.

  That came to a crashing halt with the second examination. After his long hours and endless days of studying, Ken's score was no different than the one on the previous exam.

  He failed.

  With that, for the first time, Ken realized that he might actually fail the largest course of his second curricular year. As he watched his grades fall in his other courses due to the exclusive emphasis he had placed on pathology, he realized with horror that he might even fail out of medical school.

  Such a failure would be tragic, given how far Ken had come in his young life. Ken, in fact, was much like Sue, but from a completely different background. After growing up in an alcoholic family, he felt trapped in a small town in New York's Adirondack "North Country." He drove himself mercilessly in high school and gained a scholarship to a reputable college. There he felt painfully out of place amidst peers from wealthier and less-dysfunctional families. He pushed himself to fit in, nonetheless, relying heavily on his academic achievements to carve his niche.

  Ken dreaded his returns to the family home. His father constantly reminded him that college was a waste of time, goading Ken to get a job and support himself. During his drunken outbursts, his father would harangue any family member in sight, taking a special delight in belittling Ken's manhood. Ken tolerated this stoically, setting his jaw, and resolving to move forward and win his independence. One pivotal day, after a particularly nasty fight, Ken had enough. He stood toe-to-toe with his father during one of the drunken explosions and announced, quietly but firmly, "I am going to make something of myself."

  From that time forward, Ken rarely returned to the home of his youth. "My home," he coldly announced in our first session, "is school."

  It was hard for me to believe that the Ken now sitting in my waiting room was the same fighter who battled it out with his bitter, drunken father. Ken sat slumped in the chair, and his hangdog look told me that the past few days had not gone well.

  "It's really bad," Ken announced as he planted himself in one of the two large reclining chairs in my office.

  "What's bad?" I asked. "Your studying?"

  Ken gave a brief, self-mocking smile. "I haven't been studying," he said, looking down. "I can't get myself to open the books. The test is next week, and I'm behind. I haven't even started looking at the new material."

  This was bad. Studying hard had not worked for Ken, but hardly studying was not going to be the answer. I could see that his eyes were red-rimmed from sleepless, tear-filled nights. If ever a defeated human being had set foot in my office, Ken was it. From the slumped body to the lifeless voice, Ken was a study in burnout.

  "I don't know what to do," Ken lamented. "The more I study, the less I seem to know. But I do know it. You wouldn't believe it, but when I was studying with my roommate, I was telling him the answers to the practice questions. You know what he got? An 85. Five points away from Honors. What could I say when he asked me my score? He couldn't believe I got a 68. A 68—the same score I got last time!"

  He paused, waiting for me to respond. When I did not, he turned his head downward again. "I can't do it any more . . . ," his voice trailed off

  Every ounce of my concentration was focused on Ken at that moment. I knew that whatever we accomplished in these next sessions would play a decisive role in shaping his personal and professional future.

  These are the moments therapists live for. Therapists are not so unlike major league pitchers or basketball players. The good ones want the ball in their hands when the game is on the line, when each play really counts. Most counseling sessions, like most market sessions, are routine. They offer opportunities for gains, but most of those gains will be circumscribed. It's those occasional periods of high volatility, when people and markets are reacting most emotionally, that offer the greatest possibilities of large returns.

  They are also the periods of highest risk.

  I looked at Ken's downcast expression and took yet another deep breath. The ball was in my hands. I had seen Ken for two previous sessions, but the real therapy was now beginning.

  DIVERSIFICATION IN LIFE AND MARKETS

  What is going on with Ken? Although the particulars may differ, he is not so different from many of the traders who have written to me, lamenting their lack of success in the markets.

  Ken wants to succeed in medical school. That much is certain. He so wants to
succeed that he will lose sleep and forego food to cover as much material as possible. In fact, he was willing to leave his family to achieve his goals. Although an armchair psychologist might speculate that Ken harbors an inner desire to fail, this would be mistaken. Every fiber of Ken's being wants that medical degree.

  Why? What is Ken's motivation to succeed in school?

  The obvious answer is that he wants to be a physician. That, too, however, is not quite right. Of course, he wants to be a doctor, but what does that mean to him? What is the psychological significance of the ends one seeks? Why does anyone want trading profits? Why is it so important for Ken to get that degree?

  The answer in Ken's case goes back to his confrontation with his father and, even before that, to his hard work in high school and college. Academic success has always been Ken's niche, the one arena in which he has excelled. His father could berate him and question his suitability for manly work, but he could not erase Ken's inner knowledge that he was an academic success. The philosopher Samuel Johnson, when he encountered the ideas of Bishop Berkeley, was shocked at the notion that the objects people perceive exist only in their minds. Johnson kicked a stone and announced, "Thus do I refute Berkeley!" Well, schoolwork was Ken's way of refuting his father. It was his way of establishing, "I am a success."

  Success in school possessed an additional significance for Ken: It was his ticket out of the world of his youth. Ken had felt trapped and misunderstood in his small town. He was an anomaly within his family, and he didn't really fit in with his college peers. Medicine promised a personal as well as a professional niche. For once, he could be around people like him who were doing something with their lives.

  In short, Ken's identity is intertwined with his achievement in medical school. He is not anxious simply about a test. He is petrified, frozen by the possibility of losing himself. His self-esteem is dependent on his performance: a sure recipe for anxiety and failure in any arena, whether it's exam taking, public speaking, sports, sexual relations, or trading.

  Consider a financial analogy. If medicine is Ken's trading position in life, he is fully leveraged. Ken has invested all of his emotional capital in his medical school career. His poor test performance on the first pathology exam was a normal drawdown, experienced by many other fine students. The other students could weather the drawdown because their emotional eggs were spread across many baskets. Ken, however, was not diversified. He held no cash. Given his 50-to-l emotional leverage, the normal drawdowns took a fearsome bite out of his psychological bottom line.

  Like everyone else, you are a speculator, even if you are not a market participant. If you are to live as a fully functioning human being, you must invest yourself emotionally in the elements of your life. It is only through your emotional investments that you will derive any return, in the form of happiness, contentment, and self-esteem. To be sure, there are chronically depressed and withdrawn individuals who fail to engage the world at all. These individuals realize a paltry return on their lives. In life, as in the markets, the greatest rewards come to those who invest their resources and pursue superior returns.

  Most people hold a diversified emotional portfolio, with sizable positions in romantic relationships, children, careers, and other personal activities and social relationships. Such diversification achieves an emotional benefit not unlike its financial counterpart: When things go wrong in one arena of life, the others cushion the blow. The average person holds enough noncorrelated life positions to weather most life stresses.

  Such diversification is a potent tool for managing risk. Risk, in part, represents the probability of loss. To achieve superior returns, you must invest emotional capital. But such investment also carries the possibility of significant loss. If you are highly invested in your marriage, you will be severely hurt by the loss of your spouse. If you put dedicated effort into your career, a layoff will hit you hard. When you allow something to mean a great deal to you, you open yourself to significant rewards and losses. The greats in any field of endeavor are those who have dedicated their lives to their pursuits. They are emotional investors, the ones willing to weather the heightened uncertainty that accompanies risk.

  Yet even the most dedicated artists or scientists maintain interests beyond their work, just as the most devoted spouses do not limit their interests to their significant others. Few people hold completely nondiversified life portfolios.

  But that was Ken. Ken was not dating. Ken was not sleeping. Ken was not eating. Ken had met his personal margin call with the last bit of emotional capital he had available.

  And, like many who are living for their trading rather than trading for a living, he came up short.

  THE PSYCHOLOGY OF PARALYSIS

  Framing Ken's problem as one of emotional investment helps to explain why he would stop studying at a time like this. He is like a shell-shocked trader facing a runaway bear market. Everything is on the line in the market, and he's facing huge paper losses. At some point, the pain becomes so great that he simply can't bear to face the quote machine. Like a turtle retreating to its shell, he is in a protective, shutdown mode.

  The difference is that shells really do protect turtles. Students and traders only face greater risks when their shutdown modes leave them frozen in the headlights. This lesson was driven home during the dramatic tech bear market of 2000–2001. In a year's time, the Nasdaq Composite Average lost 60 percent of its value; and many former Internet, telecommunications, and networking stalwarts took hits of 80 percent to 90 percent. Funds that had performed admirably since the cyclical bottom of 1998 suddenly found their net asset values considerably shrunken.

  During the rout, I wrote several articles for the MSN Money web site, detailing how traders deal with loss. To my surprise, the articles touched a chord among readers, many of whom wrote to me about their devastated financial plans. Several told agonizing stories of watching their retirement savings crumble before their eyes. Having eagerly anticipated their golden years, they now were faced with the prospect of returning to work and/or scaling back their retirement plans. They, like Ken, had placed their emotional and financial eggs in a single basket. Now that the basket was proving unstable, they faced an ominous future.

  So how did these readers respond to the difficult combination of risky markets and uncertain minds? To a person, they did nothing. Several expressly stated to me that they could no longer bear to look at the stock quotes in the paper. "I can't buy," one reader told me, "and it's too late to sell. All I can do is hold on and wait for it to go back up." At the time the reader wrote that, his largest holding had dropped from 75 to 35. Savings of a lifetime took a 50 percent haircut in a matter of months.

  Several months later, the stock—a Wall Street favorite and a core holding of most large, growth-oriented mutual funds—was trading at 16. My reader would need more than a quadruple simply to revisit the old high.

  Still later, the market did rebound smartly. The reader's stock made it to the low 20s. At last check, however, it was hovering just above its lows. By not acting, this investor had pursued the riskiest course of all. There are no nondecisions in the market. Every decision to hold a long or a short is a decision to buy or to sell the market now.

  If you are holding a position that you would never open as a new order, there's a good chance that you are holding more for psychological reasons than for logical ones. The decision to hold is often framed as a nondecision, when in reality it is an active choice to maintain one's exposure. In a similar way, Ken was not merely making a nonchoice in his academic life; he was actively deciding to not study. The books, like the newspaper quotes for my reader, had become too painful for Ken to open.

  Pioneering research by Amos Tversky and Daniel Kahneman helps make sense of this deer-in-the-headlights phenomenon. They found that most individuals are risk-avoiders in handling gains, but risk-takers when faced with losses. In the research example given in Scott Pious's text The Psychology of Judgment and Decision Making, an indi
vidual is given $1,000 and then offered a choice between two alternatives: She can take a 50 percent chance of gaining $1,000, or she can take a sure gain of $500. Under such conditions, 84 percent of subjects choose the certain gain. If, however, the subjects are presented with a scenario in which they are given $2,000 and then offered a choice between a 50 percent chance of losing $1,000 and a 100 percent loss of $500, nearly 70 percent take the riskier 50 percent bet. In a nutshell, people are far more apt to take chances to reduce losses than they are to extend gains.

  Many a winning position has been cut short in the market, and many a loss has been extended, precisely out of this psychology. Ken, like the readers responding to my MSN Money articles, implicitly takes the high-risk bet because of an inability to accept the paper loss. Frozen, he takes the opposite of a solution-focused approach: He continues to do what isn't working.

  The problem is that people's strategies for managing uncertainty often clash with the strategies needed to manage the objective risks in a situation. To an outside observer, the investor who stops looking at quotes when the market moves against her and the student who discontinues his studies when he is failing are behaving in self-defeating and even masochistic ways. From an emotional vantage point, however, their inactivity makes perfect sense. They are protecting their psyches, not their portfolios or report cards. Like children who hope to escape the bogeyman by drawing the bedcovers over their heads, they hope to make unpleasant realities vanish by banishing them from consciousness.

  A surprising number of self-defeating patterns can be viewed as misguided attempts to manage the risk and uncertainty of threatening situations. Two years ago, I met with a young man named Bob who was desperate to begin a dating relationship. He had been on a few casual dates, but he hadn't had a meaningful relationship in over a year. Finally, he met someone who interested him. She talked with him after class and seemed similarly interested. He was ecstatic, and he couldn't stop thinking about her.