Best of TTU – You Don’t Need To Be A Genius If You Can Stick To A Plan

In the previous Best of Top Traders Unplugged, we went back in time to re-visit some of the key lessons that many investors learned during the Financial Crisis of 2008. It was my way of reminding myself, and you, of something that we as investors must never forget.  Today, Robert Carver goes much deeper into the human psychology that makes us ill-equipped to deal with our emotions in a rational way when it comes to making good investment decisions, and also, how you can overcome this behaviour and make your own plan for financial success.  So enjoy these unique takeaways from my conversation with Robert, and if you would like to listen to the conversation in full, you can go to Top Traders Unplugged Episode 89 and Episode 90.
The Hindrance of Human Instinct
Rob: ...So I’m genuinely interested in educating people and trying to explain to them that they need to be more realistic. That’s a completely different market place from where you are trying to compete with people who are trying to make the most outlandish claims to stand out from the pack of people making similar outlandish claims.
Niels:  I agree with that completely. I think it is evident from reading your book that, that is the fundamental motivation. Now you touched already upon the point about the flawed human brain in your book, and you end up talking a little bit about some of the temptation of taking profits early and letting our losses run, and that’s really how we as human beings are wired. Tell me a little bit more about that and what it really means when it comes to trading if you get this balance the wrong way around so to speak, and what you found when you test this kind of human behavior if I can call it that.
Rob:  So the natural human instinct when you see a position rise in price and you're long, is to say… is to want to take a profit. And this comes down to essentially that kind of strong feeling and you want to kind of lock that in. And the reason you want to lock that in is that you want to prove that you are right.  It’s the overwhelming human emotion to prove that you are doing the right thing and it’s called confirmation bias in the literature. Now when its stocks falling, if you sell a loss, then you’re going to be proving that you are wrong and nobody wants to do that. So what you actually then want to do is hang onto that position and hope it goes up in value. And as it keeps falling of course you have the same conversation with yourself until you’re forced to sell and perhaps because you’ve run out of money.

So it’s really about the way the human brain is treating unrealized losses and unrealized losses differently. We are thinking about them differently. Even though they’re exactly the same. And you know this kind of mindset that it’s not a profit until you’ve sold it and it’s not a loss until you’ve taken the loss. It’s completely wrong.
Now it’s very easy to think about a sort of pattern of price where it would actually make sense to buy on a small profit, and that would be if the market was trading in a small range. Now the problem is that most of the time markets don’t do that they trend. This isn’t the time for that kind of theological argument about whether trend following is a good thing or a bad thing.

'...even in the large institutions that trade systematically, you still have debates about whether we should override the system, or cut the system's risk because of something that is going on in the world.'

Certainly in the past people like Winton have done tests over hundreds of years of data where it is available, and markets have in the past exhibited a behavior where they’re trending. So if markets are going to trend and this behavior where you’re going to sell at a small profit and cut only when you’ve got a huge loss is exactly the wrong thing to do. You should do exactly the opposite of that, which is what a trend following system will do....