In today's Mind Over Money podcast, I took a closer look at decision-making. Specifically, I wanted to explore what often gets in the way of good decision-making, especially when the financial landscape is shifting like it is now.
And that means we have to focus on the cognitive biases, those mental short-cuts, filters, and processes that help us make decisions faster.
Because those same short-cuts just as often short-change us from the best outcomes in everything from stock-picking -- and its twin challenges of risk and profit management -- to car shopping and job hunting.
Remember that this podcast wants to come at our “brains on risk” from 3 distinct angles:
Angle #1 is behavioral finance. This is the field of cognitive biases and heuristics that Daniel Kahneman and Amos Tversky broke big ground for in the late 1960s and 1970s. I call this way of knowing about our decision-making the OUTSIDE-IN approach because the behavioral researchers and social scientists are conducting problem-based experiments and questionnaires with thousands of people. They examine behavior in different, repeatable “decision situations” and then draw conclusions from the data patterns about what we humans tend to do and why.
Angle #2 is neuroscience. What science has discovered about our brains through advanced imaging techniques in the past two decades could fill lifetimes of research projects for the next few generations of curiosity seekers. I call this way of knowing about our decision-making the INSIDE-OUT approach because the neuroscience researchers are focused on the brain structures, functions, and biochemistry that cause our behavior.
And this reminds me to remind you about episode #2 of Mind Over Money recorded on Nov 8 where I spoke with Denise Shull of The ReThink Group. Shull earned her Masters in the Neuroscience of Emotion at the University of Chicago and then went on to become a trader and a trader’s coach, working for many top banks and funds. We had a great discussion about understanding how emotion is involved in all our decisions.
Shull’s consulting work really took off in 2003 when she combined her research with that of Antonio Damasio, Professor of Neuroscience at the University of Southern California. Damasio and his colleagues found that if emotional centers of the brain were damaged or in some way disabled, we wouldn’t be able to make decisions at all, or at least not with the ease and effectiveness we do hundreds of times during the day.
So Denise Shull trains her clients to become more aware of their emotions during trading, not to shun them. And she also started doing this in 2016 for the US Olympic Snowboarding Snowcross team. Be sure to catch episode #2 of Mind Over Money with the title “Train Your Brain for Better Trading” to hear all about her work.
How Smart Traders Re-Wire Their Brains
The third angle that I approach the collision of psychology and markets through is the investors and traders themselves, from the so-called Market Wizards, the books by Jack Schwager that interview the highly successful, to the rogues and gamblers who lose it all. This 3rd angle of knowing about our “brains on risk” was actually where I started my intellectual journey here 20-some years ago, observing traders in the commodity and futures pits of Chicago.
That’s because smart traders who’ve learned to survive in the pits or behind the screen share many common traits that the scientists would admire in terms of being aware of their biases and emotions so that they can make better decisions, more consistently, for long-run success. Short-term trading is arguably one of the most mentally-challenging occupations there is because, as I used to argue, our brains are hard-wired to make quick decisions that break the golden rule of trading.
That rule is: cut your losses short, and let your winners run. Most new traders seem to instinctively do the opposite because they are loss averse and eager to capture gains. This is the mathematical recipe for failure in trading because it guarantees that even if you are right 60% of the time, you will lose everything as you let losses pile up bigger than winners.
Ray Dalio on the Big Shift
Speaking of Market Wizards, Ray Dalio, the head of the largest hedge fund in the world, Bridgewater with nearly $200 billion AUM, put out a new investment letter today, November 15, to opine on how the global-macro investing landscape will change over the next few years after last week’s GOP election sweep. Obviously we are seeing many of these new trends already emerging in full force, like the bond bubble popping, and the US dollar rallying as inflation expectations rise, and the flood of money into domestic small-cap companies, especially Financial and Industrial/Manufacturing stocks, at the expense of big-cap Tech
Dalio suggests that these big shifts could rival the reversals of prior decades. Here’s what he said...
"...the main point we’re trying to convey is that there is a good chance that we are at one of those major reversals that last a decade (like the 1970-71 shift from the 1960s period of non-inflationary growth to the 1970s decade of stagflation, or the 1980s shift to disinflationary strong growth). To be clear, we are not saying that the future will be like any of these mentioned prior periods; we are just saying that there’s a good chance that the economy/market will shift from what we have gotten used to."
Now, when we are trying to adjust to new market conditions, this is when we need to be aware of our biases and emotions even more. Heck, the last 7 years of this steady bull market and QE and a 2% GDP economy still fooled people into following their biases and emotions instead of following the market higher by “BUYING the DIPS” with a clear, long-term investment plan.
So it’s never easy. But as I teach people both with short-term trading and long-term investing, having detailed plans of what you will do under different scenarios is the key to effectively managing any type of change or surprise. Market dips in a growing economy, for instance, become recognized as great opportunities, not sources of fear and loathing.
Most investors don't review their portfolios and make new plans for re-allocation often enough. And there are many blindspots and biases that prevent us from opening up that hood and getting a much-needed tuneup.
But now would be an especially good time to confront those obstacles and get ready for the next new trends.
Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the Tactical Trader portfolio.
