Your Inner Monkey

Your Inner Monkey

By far, the biggest challenge to anyone attempting to achieve consistency and to make a business out of trading is the emotional response to losses. Now I’m not going to regurgitate many books written by Steenbarger ( 1st , 2nd and 3rd books), Kiev and others. I know, however, that this is the toughest obstacle to overcome within ourselves on our journey to achieving consistent and stable profitability in trading.
The idea of this post was prompted by a book I just finished reading. It is called Superfreakonomics by Levitt & Dubner. I loved reading their first book, so I got the 2nd when it came out and finally got through it.
In the last chapter…the epilogue of the book, Levitt & Dubner speak of a series of experiments conducted on capuchin monkeys by a micro-economist named Keith Chen. Chen taught monkeys to use money to trade for food. A key experiment, in my opinion, was one where they introduced two gambling games. In one game a monkey is presented with one grape and by a random coin-flip either received only that grape or got a bonus grape too.
In a second game, a monkey is presented with two grapes and by a random coin-flip either receives the two grapes or has one grape taken away. In both games the average outcome of the game is one grape, but the monkeys strongly preferred the first game that started with only one grape. The monkeys apparently suffered from "loss aversion" where the pain from losing one grape was greater than the pleasure from gaining one.
Well guess what? Your natural response as a trader connected to technology, that is setting you millennia apart from being a primate, is exactly the same. It has been documented over and over that most people of various backgrounds, ethnicities, ages and aptitude all respond the same way. Humans would rather receive a small, but more guaranteed, reward rather than increase the potential of loss no matter how small that potential is.
Do you doubt this conclusion about humans? Consider the following poll that I did today of my followers:
Question:

There is an outbreak of Asian Flu at your location. If nothing is done, they predict that 600 people will die. Two courses of action have been suggested. If program A is adopted, 200 people will be saved. If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.

Which of the two programs do you favor?

Result (302 vote sample):

Does this surprise you? It should because, on average, Program A and Program B are identical. But Program A seems to imply a bigger loss when actually Program B is more risky.

If we restate the question this way, "Two courses of action have been suggested. If program A is adopted, 400 will die. If program B is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die. Which of the two programs do you favor?" The expected response will be overwhelmingly for Program B even though, again, the outcome is the same.

Why does this happen? Because the second question is very clear about how much loss there will be and so they will take a greater chance for the probability that more lives will be saved, so we, humans, will take extra risk to save lives (or avert losses).

Interesting; don’t you think?

How did it feel the last time you covered a short at the top? How about taking a small loss right before the market violently moved in your direction? Consider that even though you got upset, you would be happy to do that again than to experience staying in the planned position longer and have it go violently against you even if that can only happen 10% of the time. Trust me, it sounds like 10% would make it a no-brainer, but you will find an excuse to close the position for a small loss.

Is it any wonder that most traders hang on to losing trades a long time and let go of winning trades quickly? Why do you suppose that is? Yep…it is that crazy monkey within us.

Many will respond by trying to desensitize themselves to emotions while trading. Don’t try to be unemotional, this is useless. In essence, trying to maintain an unemotional disposition while trading makes as much sense as maintaining slow breathing while running up 20 flights of stairs. It won’t last very long before something is going to give and the outcome may be a concussion from passing out.

What can you do about it? It is like beating nervousness on speech day at school or performance anxiety on a stage. The best approach is to be well prepared coupled with your ability to bring awareness to your thoughts and emotions while trading. The second thing that must be addressed is to set a predefined and comfortable risk parameter and to accept it. This will more probably lead to your logical mind remaining objective while the market bounces around your entry before the move actually happens.

I will address this topic in a webinar at a later date. I hope you found this interesting. Good luck.

7 Comments
  • Daria
    Posted at 14:57h, 02 June Reply

    Kahneman and Tversky did that research with humans in the 70's. We seem to be "hard wired" to be risk seekers when it comes to losses and risk adverse when it comes to gains.

  • Dre
    Posted at 15:20h, 02 June Reply

    good experiment.
    If there is any technique you can find on how to minimize emotional intervention, please share. In the mean time, Mark Douglas book is a good one for reading, but in practicality it is easier said then done.

  • steve
    Posted at 20:26h, 02 June Reply

    Let's not forget about the emotional attachment to gains, which can, for some, be an equally limiting and detrimental factor. Mark Douglas's first book touched on this, and made us think about whether or not we deserved any gains at all. If taking 2-3 ticks out of a great trade setup is common, how probable is this behavior as fear of gains is the same as fear of losses?

  • Urszula
    Posted at 06:42h, 03 June Reply

    A terrific post.
    It concerns me when traders (most often male) strive to be "unemotional" when trading. Not possible. Equanimity is the state I aim for, via a very simple meditation called *Brain Cleansing*. Even 10 mins makes a significant difference to my state of mind; 20-30 is my daily aim, shortly before commencing trading. Being prudent, patient and disciplined every day is not easy. Meditation will affect the way you trade – and there's no downside 😉

  • AaronP
    Posted at 10:53h, 27 June Reply

    FT71,

    I'm confused about this section of your post-
    "Consider that even though you got upset, you would be happy to do that again than to experience staying in the planned position longer and have it go violently against you even if that can only happen 10% of the time."
    It sounds like here you are saying traders on average would rather take a guaranteed small loss than a chance at a larger loss or a gain. This contradicts what you said shortly after-
    "Is it any wonder that most traders hang on to losing trades a long time and let go of winning trades quickly? Why do you suppose that is? Yep…it is that crazy monkey within us."
    Am I reading this correctly?

    Aaron

  • z
    Posted at 20:31h, 15 August Reply

    As a follow up to this post, I think it is important to see this video demonstrating monkeys make the same decisions: "Laurie Santos: A monkey economy as irrational as ours"

    http://www.ted.com/talks/laurie_santos.html

    Posted for archive purposes

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