Nobel Laureate and the Rice Trader –
Psychology’s Role in Trading Strategies Part V
My son Josh is playing in a fantasy baseball league with his friends from school. The
whole concept of fantasy sports is an interesting one. People get to be general managers of teams (baseball, football, basketball, etc.). Their teams score points based on the statistics that their players generate during the week. It’s truly a numbers game; it doesn’t matter if a player’s team wins or
loses. As long as they put up good numbers, a fantasy owner is happy.
This mindset can creep into the thoughts of markets participants as well.
Many traders and investors are in love with the numbers. Winning percentages, expectancies, moving averages, stochastics, P/E ratios, you name it. This love of numbers can verge on the obsessive. At the extremes, people can become like fantasy sports participants and get so obsessed with the numbers that they miss the big picture – profitable trading.
I started this series on Nobel Prize winner Daniel Kahneman and famous rice trader Munehisa Homma because they both wrote that the numbers are important in decision making, but our thought process, psychology and decision making shortcuts are much more important!
In a way, Kahneman put some quantitative experimentation behind the trading psychology espoused by Homma. A couple of weeks ago we talked conceptually about three decision making shortcuts that get traders and investors into trouble. Today, let’s do some quantitative exercises that shed some light on these decision making inefficiencies.
Three Shortcuts That We Shouldn’t Take
• We hate losses more than we love wins. Dr. Kahneman found that people
overreact just to avoid losses. As traders and investors, we tend to do the same thing. Traders are drawn to systems and strategies that have high winning percentages when there are other issues that are equally important. Try this question:
Would you rather have a strategy that wins 60 percent of the time or one that wins 40 percent of time? Think about this one for a second or two before you respond. The answer is at the bottom of the article.
• We love certainty and avoid uncertainty. People will make irrational choices to avoid an uncertain outcome. This phenomenon helps to keep insurance premiums and extended warranty prices high. As traders and investors, we also pay for lots of “extras” in an effort to reduce uncertainty. We pay for extra data, new systems, indicators and research and real time news feeds all in an effort to reduce our uncertainty about the markets. Approach uncertainty as a normal part of your trading business and as something you can understand (at least in terms of percentages). If you approach each trade as a decision with a certain percentage chance of succeeding, you will be much more likely to quickly take the trade and much less likely to
overreact if the trades goes against you. How do you handle uncertainty? Choose between these trading strategies:
Would you rather have 60% winners with losers twice as big as the winners OR 40% winners with the winners twice as big as the losers?
Once again an explanation is found at the bottom of the article.
• We draw big conclusions from a small number of examples. Traders and investors tend to concentrate on a few big ideas instead of looking at multiple opportunities for profits. The number of opportunities a strategy offers us is as important as its winning percentage or the size of its winners. Once again, pick one of the following strategies:
o Strategy A: 75% winners, winners twice as big as losers, trades once a month.
o Strategy B: 50% winners, winners twice as big as losers, trades once per week.
Answers are found at the bottom of the article.
Understanding the numbers can help us to overcome trading by emotion and can keep us from using ineffective decision making shortcuts. BUT – understanding our personal psychology and the mass psychology that drives the markets is even more important (this is another of the big edges that Homma employed).
I still haven’t found a copy (in English) of Homma-san’s book
The Fountain of Gold - The Three Monkey Record of
Money, so if anyone has any leads, I’d greatly appreciate an e-mail sent to drbarton “at” iitm.com (replace the “at” with the symbol).
Until next week…
Here are answers and explanations for the questions posed above:
Q: Would you rather have a strategy that wins 60 percent of the time or one that wins 40 percent of time?
A: The best answer is that we don’t have enough information to make this choice! However, many people jump into a trading strategy just because “it wins a
lot.” As we’ll see in our other answers, to evaluate the strategy, you also need to know how big the average winner and average losers are and how often it trades.
Q: Would you rather have 60% winners with losers twice as big as the winners OR
40% winners with the winners twice as big as the losers?
A: The system that wins 60% of the time actually loses money over time, because the winners are only half as big as the winners! Here’s the math:
(0.6 x 1.0) – (0.4 x 2.0) = –0.20
You lose twenty cents for every dollar you risk.
The system with 40% winners makes money of the long haul:
(0.4 x 2.0) – (0.6 x 1.0) = + 0.20
You make twenty cents for every dollar your risk.
Q: Pick one of the following strategies:
Strategy A: 75% winners, winners twice as big as losers, trades once a month.
Strategy B: 50% winners, winners twice as big as losers, trades once per week.
A: Both strategies make money, but even though Strategy B makes less per trade, it makes more per year. The math for one year of trading goes like this:
((0.75 x 2.0) – (0.25 x 1.0)) x 12 trades per year =
You make 15 times your average risk amount for the year.
((0. 5 x 2.0) – (0.5 x 1.0)) x 52 trades per year =
You make 26 times your average risk amount for the year.
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. He is a regularly featured guest on both Report
on Business TV, and
WTOP News Radio in Washington, D.C., and has been a guest
on Bloomberg Radio. His
articles have appeared on SmartMoney.com and Financial
You may contact D.R. at
“drbarton” at “iitm.com”.