THE CONDITIONING OF MARKETS
A large part of money management follows from a deep appreciation of fat tails. Market returns are not normally distributed; they show a higher proportion of extreme occurrences than you would expect from a simple flipping of coins. This is true across all time frames. The odds of a multiple standard deviation move against you (or for you) are sufficiently high that, if youre in the market frequently over a long period of time, you will surely encounter those periods in which markets stay irrational longer than you can stay solvent.
The distribution of market returns is also leptokurtic: it is far more peaked around the median than a normal distribution. This implies that market moves revert to a mean more often than we would normally expect by chance. Just as a market seems to be moving in one direction trendingit reverses course and finishes little changed.
It is difficult to imagine a situation better designed to create frustration. Markets produce large moves more often than would be expected if returns were distributed normally, which leads traders to seek large, trending moves. But markets also revert to mean returns more often than we would expect in normal distributions, creating many false trends. If you trade a countertrend strategy, you run the risk of being blown out by a multiple standard deviation move. If you try to jump aboard trends, youll find yourself chopped to pieces during false breakouts.
The very structure of market returns ensures a high degree of psychological challenge for traders.
The tendency of markets to make extreme moves amid frequent mean reversion creates interesting and important psychological challenges that affect self-coaching. To fully appreciate this, we need to understand the dynamics of behavioral conditioning.
Lets say that, each time I ring a bell, I hit you over the head. Soon, youll learn to duck as soon as you hear the bell. That is a conditioned response. Days later, you might be in a different location and will still duck if the bell sounds. Its automatic; not a behavior guided by explicit reasoning. Youve learned to associate bell and pain, just as Pavlovs dogs associated a ringing bell with the appearance of meat. Bell rings, dogs salivate. Bell rings, you protect yourself.
Now lets take our experiment a step further. I ring a similar but different bell and once again hit you over the head. Before long, you learn to duck whenever you hear any bell. This is called generalization. Your conditioned responses (the ducking) have now extended to a class of stimuli similar to the original one.
Much of what we call traumatic stress is the result of such conditioning. In the Psychology of Trading book, I mentioned my car accident in
which I was thrown from a vehicle while riding as a passenger. Just as a result of that single, powerful event, I developed an anxiety response anytime I subsequently sat in the passenger seat of a careven when the vehicle wasnt moving! I had learned an associative connection between being a passenger and extreme danger; the conditioning stuck with me even though I intellectually knew it made no sense.
Many of our extreme reactions to market events are the result of prior conditioning.
Powerful positive emotional events can yield the same kind of conditioning. The high obtained from certain drugs can be so strong that some people will develop addictive patterns after a single use. Underlying the addiction is the learned connection between the high and the use of the substance. That, too, overrides reason and reorganizes behavior.
One of my greatest failures as a trading coach occurred with a young trader who experienced early market success. He took the time to observe markets, learn short-term patterns, and track his own trading. He started trading small and learned the important lessons about waiting for good entry points, cutting losing trades, and letting his winning trades run to their target points. The trading firm was happy with his progress and gave him significantly greater size to trade. That was where I went wrong. I should have stepped in and demanded that the traders increase in risk be more graduated. Instead, armed with his new size, the young trader decided he would try to compete with the more experienced traders at the firm. He traded full size in his positions and his profits and losses swung wildly. Unprepared emotionally for those swings, he became impulsive and, one day, abandoned all discipline, blowing himself up on a single trade he allowed to get away from him. He never recovered from that loss and eventually had to start over at another firm.
It is impossible to remain emotionally stable if you greatly amplify your P/L swings.
When traders are undercapitalized and still hope to trade for a living, they too are impelled to take high levels of risk to achieve their desired returns. The result is that their portfolio swings wildly, with gains and losses that represent a large portion of total account value. These financial swings bring emotional swings, both positive and negative. The larger the financial swings, on average, the larger the emotional swings. The larger the emotional swings, the greater the potential for the development of learned, conditioned responses that disrupt future trading.
When a trader undergoes an emotionally harrowing loss, many of the situational factors associated with that trade may become associated with the emotional pain. Some of these situational factors, from the traders physical state to the particular type of movement in the market, may be quite random. Nonetheless, they can trigger the emotional pain, much like sitting in a passenger seat triggered my anxiety following the automobile accident. A trader who consulted me about problems pulling the trigger on good trade setups experienced precisely that problem. He had lost significant money shorting the market during an uptrend, incurring several large losses. Subsequently, even when his trades were small in size, he felt fear whenever he tried to short the market. The feelings associated with his loss came back as a conditioned response, inhibiting his trading. This is the dynamic behind the flashbacks that occur during post-traumatic stress: stimuli associated with the initial trauma trigger memories and feelings from that painful incident.
The problem may have been just as severe had this trader made large money on the initial trade instead of losing. The emotional impact of a windfall profit, like the impact of a crack cocaine high, would bring its own conditioning, leading him to pursue similar gains (and highs) in future trades. It is poorly understood by traders that, psychologically, outsized gains are just as problematic as outsized losses. The fat tails of returns threaten fat tails of psychological response, interfering with sound perception and decision-making.
For this reason, when youre your own trading coach, you dont want patterns of extreme returns. Steady, consistent profits are far better for psychological performance than wild swings up and down, even though they may lead to the same ultimate returns. Stated otherwise, good riskadjusted returns are better for the psyche than extreme patterns of returns. Its not how much you make, but how much you make per unit of risk taken that will keep you in or out of the performance zone.
Your assignment for this lesson is to track the variability of your returns as intensively as your overall profitability. By variability of returns, I mean the absolute value of daily/weekly changes in your portfolio value: how much your account swings up or down on average each day. As markets change in their volatility and as you shift in your level of conviction about trades, youll see changes in this variability. This tracking will tell you when you run more and less risk. On the whole, youll want greater variability when you trade well and have many solid ideas; youll want to cut your risk (lower the variability of returns) when you dont see markets well and when good trading ideas and moves are scarce.
Track the volatility of your returns, not just their direction. Volatility affects trading psychology every bit as much as winning and losing.
When you track the variability of returns, youll also be able to see when your swings in profit/loss are outliers from your historical norms. This will be an excellent alert that your levels of risk may be sufficient to generate those large emotional swings that will produce unwanted conditioned responses. Traders tend to love volatility when theyre making money and hate volatility when theyre losing. Psychologically, it makes sense to keep the volatility of your returns within bounds: markets may possess fat tails, but with prudent position sizing, your returns can remain stable. You dont want markets conditioning your learning: you want to be your own coach, directing your own learning.
The psychological research on trauma suggests that processing a very stressful event verballyout loud or in writingcan be extremely helpful in making sense of that event and divesting it of enduring emotional impact. When we repeat something again and again, it becomes familiar to us and no longer evokes powerful emotion. If you encounter outsized gains or losses in your portfolio, double down in your use of the trading journal or in your conversations with peer traders to thoroughly process what happened and why. As noted above, this process is just as important following large gains as following large losses. When highly emotional events bypass explicit processing, that is when we are most vulnerable to the effects of conditioning.