. But, in general, it is a congruence of character-istics, not any one individual trait, that leads to true excellence.
To achieve greatness in investing, education is the ﬁrst step. You’ve gotto know what you’re doing in the markets. What is your strategy? Why is itsuperior? How will you manage volatility?
The next step is a self-evaluation. Identify your strengths and weak-nesses and inventory your resources. What is your psychological Achilles’heel, and how will you protect it? Where do you draw your social supportand your business network? Do you have a safety net, a fall-back plan? It’snot simple to do a full self-assessment, in part because of the numerousself-deceptions and biases that everyone is subject to.
Biases can seriously impair ﬁnancial performance. They promptportfolio managers and individual investors to overtrade, feel excessivelyoptimistic, and hold losers too long. Financial analysts are particularlysusceptible to social biases such as herding. Professional traders take toomuch risk after recent losses. Such biased behavior is rooted in the brain’shard-wired cognitive and emotional systems. As a result of their deep
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subconscious origins, such biases are challenging to identify in oneself,much less to correct.
Small positive changes in psychological well-being, mental training,and physical health improve the probability of successful decision making.A slightly increased probability of success, over years of decision making,leads to better long-term outcomes.
This chapter is about the simple steps you can take to optimize yourmind for reducing biases and improving investment decision making. It re-views fundamental concepts in psychology, offers brief lessons on emo-tional adaptability and coping skills, and outlines steps necessary to de-veloping self-discipline. This chapter should help you start the journey,and maybe provide some help along the way, but it will not fundamentallychange who you are. In the end, it’s what you make of this information thatcounts. As motivational philosopher Jim Rohn puts it, “No one can do yourpush-ups for you.”
DO IT FOR LOVE, NOT MONEY
I’ve heard some investors describe their goals as earning “obscene”amounts of money or accumulating “generational” wealth. However, thepursuit of proﬁt for its own sake can quickly go awry. Such motivations in-volve the ego in decision making and increase emotional reactivity to out-comes. Furthermore, pursuing wealth as a goal is a symptom of decreasedpersonal well-being and low self-esteem.
Individuals who identify “aspirations for ﬁnancial success” as an im-portant personal value have lower levels of “psychological vitality” and“self-actualization” and more physical complaints than others. People whoendorse aspirations for self-acceptance, afﬁliation, community feeling, andphysical health have superior well-being and less distress overall.1 It mayseem paradoxical, but pursuing proﬁt as one’s primary goal can be a signof emotional ill health.
Of course, it is only natural that people in the ﬁnancial industry are in-terested in making money. However, when money becomes the goal, ratherthan a by-product of enjoyable work, then emotional stability is apt tosuffer.
The best investors, bankers, and businesspeople do their jobs well notfor the ﬁnancial rewards, but because they love them. Management guruPeter Drucker left investment banking because he wasn’t passionate aboutit: “I was doing very well as a young investment banker in London in themid-1930s, and the work clearly ﬁt my strengths. Yet I did not see myselfmaking a contribution as an asset manager. People, I realized, were what
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I valued, and I saw no point in being the richest man in the cemetery. Ihad no money and no job prospects. Despite the continuing Depression, Iquit—and it was the right thing to do.”2 The world is a better place becauseDrucker followed his career passion.
A focus on monetary outcomes also biases investing decisions. Sometrading books and articles recommend a “Zen” (nonattachment) approachto short-term proﬁts and losses.3,4 Ego attachment to gains and losses in-duces greater emotional reactivity due to the comparison of short-termprogress against expectations and goals. Detachment from outcomes andfocus on the investment decision process improves emotional stability dur-ing volatility and yields greater long-term returns as strategy is graduallyhoned.
MONEY CHANGES YOU
Researchers have found that thinking about money unconsciously inﬂu-ences behavior, and the effects are not subtle. In a series of experiments,seeing a money cue (such as a wall poster depicting cash or unscramblinga sentence with a ﬁnancial subject) changed how people solved problemsand related to others. Money cues increased subjects’ self-sufﬁciency andgenerated the desire to be free of dependency and dependents.
The subjects who were primed by money cues waited longer to askthe experimenter for help during a challenging task (314 seconds versus173 seconds), spent half as much time assisting a confused peer (67 sec-onds versus 148 seconds), and donated half as much money ($0.77 versus$1.34) to the “University Student Fund” drop-box when they left the exper-iment room. In further experiments subjects primed with money preferredto play alone, work alone, and put more physical distance between them-selves and a new acquaintance (118 cm versus 80 cm).5 Overall, money-primed subjects became more self-sufﬁcient, less generous, and more de-tached from others. Such effects of “money consciousness” are generatedbeneath awareness, and as seen above, they have a profound effect on so-cial interaction and behavior.
EMOTIONAL DEFENSES
The brain doesn’t like the discomfort of negative emotions, and ithas devised strategies to avoid dealing with such feelings as anxiety,disappointment, and anger. Emotional defense mechanisms includingdenial, repression, and rationalization attempt to keep the discomfort
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unconscious. Negative emotions often linger underneath awareness,subtly inﬂuencing judgment and behavior. Insight is difﬁcult and can bepainful. The real reason people don’t learn from their mistakes (or by ob-serving the mistakes of others) is that they refuse to, and are often unableto, acknowledge those mistakes in the ﬁrst place. Accepting responsibilityfor error is simply too painful for most people. As a result, it is extremelydifﬁcult to gain awareness of unconscious negative emotions.
Earlier in the book, I described experiments in which participants’emotions were manipulated beneath their awareness, and their judgmentsand behaviors changed as a result. The subjects themselves reported feel-ing the same both before and after the subliminal emotion induction. Un-conscious emotions affect people beneath their awareness, yet they haveprofound effects on how people make decisions. In order to address andmanage unconscious emotions, it’s useful to understand how they arise.Much of unconscious emotional experience is fueled by internal predis-positions, while other aspects of emotional life are learned over time orexperienced in reaction to events.
There are techniques available for using the conscious mind offen-sively against emotional biases—exposing emotional undercurrents andusing them to one’s advantage. These techniques fall under the rubric ofpsychotherapy and self-help and are discussed in the following chapter.
THE PURSUIT OF HAPPINESS
Some people chronically wear “rose-colored glasses.” Their positive senseof well-being is, to a large extent, inherited. In general, an individual’s av-erage level of well-being correlates with that of his or her parents. Theheritability of happiness may be as high as 80 percent,6 though 50 percentis a more widely accepted number.7 It appears that everyone has a baselinelevel of happiness, which is determined primarily by genetics. While theremay be signiﬁcant variation in levels of happiness in the short term, thelong-term average will be around a partially inherited baseline.
Beyond inheritance, one’s learned coping strategies for success, fail-ure, ease, and adversity contribute to one’s level of well-being. There arealso short-term emotional inﬂuences from unconscious emotions, suchas those generated by the brain’s comparator in response to short-termevents, such as an unexpected ﬁnancial windfall. But short-term emotionsdon’t last long.
Perhaps surprisingly, people become emotionally acclimated to theirnew state of affairs after major life events, returning to their chronic base-line. For example, individuals who receive a ﬁnancial windfall will initially
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be happier, but over a year their life satisfaction level returns to nearits baseline state, which is called “hedonic adaptation” in the psychologyliterature.8 Happiness researchers have shown that recent lottery winnerswere not happier than nonwinners,9 and recent victims of paralysis wereonly slightly less happy than others after one year had passed.10 Peoplereadily adjust to the facts of their new situation, and they reset their expec-tations accordingly.
The goal of psychotherapy is to increase a client’s psychological adapt-ability by increasing their awareness of the connections between thoughts,feelings, and subsequent decisions. One study showed that talking aboutand analyzing the worst experience of one’s life for 15 minutes per day forthree days increased life satisfaction and physical and mental well-beingwhen measured four weeks later. The same researchers found that simplythinking about the same bad experience, without analyzing, speaking, orwriting about it, did not improve well-being.11
Because people are typically unconscious of their underlying feelings,both Western psychotherapy and Eastern contemplative techniques pro-vide tools for gaining awareness of and working through feelings. Thesetools are not simple or easy to use. In fact, they involve serious time andenergy commitments. And if you engage in one of these paths, you’ve gotto ask yourself if you’re ready to dedicate the time and effort required toﬁnd a therapist or meditation technique that ﬁts your needs.
NEUROPLASTICITY
Where we can see the error of our ways, focus our corrective efforts, andpractice with discipline, our brains will slowly rewire. Some hardwired bi-ases can be mitigated via a process of neuronal resculpting called neu-roplasticity. Neuroplasticity refers to neurons’ tendency to change theirstructure and function in order to adapt to the demands of new environ-ments. For a pianist, the neurons coordinating and controlling rapid ﬁngermovements will be more extensively networked and that area of the brainis physically larger than in the brain of a nonpianist. Such extensive neuralnetworking occurs over time, due to practice and concentrated use. Peoplewho do not practice the piano will not have extensive networking of theseneurons.
Similarly, if one is practicing techniques for enhancing emotional in-telligence, then it’s likely that the one’s ability to attend, maintain self-awareness, and exercise impulse control will be strengthened. TibetanBuddhist monks spend many hours daily meditating. In one unpublishedstudy, brain monitoring (fMRI) of Buddhist meditators who had practiced
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greater than 10,000 hours of compassion meditation were compared withthose from a group of novice meditators. At baseline, the monks’ brainsshowed greater activation in brain areas related to positive feelings (leftprefrontal cortex) and less activation in areas associated with negativeemotions such as anxiety and anger (right prefrontal cortex) than did thenovice meditators.12
In a study using electroencephalography (EEG) to monitor brainwaves in the cortex, researchers found that Buddhist meditators have veryhigh levels of gamma-wave synchrony (relative to novices) when meditat-ing. It appeared that through meditation practice, the monks had learned tofocus and synchronize their brain activity, resulting in enhanced attentionand improved mood. “Our study is consistent with the idea that attentionand affective processes, which gamma-band EEG synchronization may re-ﬂect, are ﬂexible skills that can be trained.”13 According to a Wall StreetJournal commentary, “That opens up the tantalizing possibility that thebrain, like the rest of the body, can be altered intentionally. Just as aero-bics sculpt the muscles, so mental training sculpts the gray matter in waysscientists are only beginning to fathom.”14
The chief lesson of neuroplasticity is that with guided training, fre-quent practice, and self-discipline, the structure and function of the braincan be altered. Mental and emotional exercise is like athletic exercise.When directed effort is applied, the body and mind can be trained to fa-cilitate achievement. Mental “athletes” don’t show their genius outwardly,until they are making decisions. Their prowess can be observed in their re-sponses to new information, how they handle price volatility, losses, andgains, and in their analytic techniques and intuitive judgment.
CHEMICAL STABILIZERS
Dietary chemicals, medications, and illicit drugs have numerous effects onﬁnancial judgment (as reviewed in Chapter 4). Dietary substances, such asthe fats consumed, caffeine intake, and alcohol consumption can changedecision making profoundly, yet few investors consider these substancesas problematic. Probably the reason chemicals and diet are largely ignoredby traders and investors is that the effects are subtle. Additionally, sub-stances such as caffeine can be beneﬁcial for some individual investorswhile impairing the cognitive ﬂexibility of others.
While dietary changes can lead to more ﬂexible and adaptive decisionmaking, there is no medication that does the same in all market conditions.For those with existing medical and psychiatric conditions, some medica-tions appear to improve ﬁnancial judgment and behavior. Some investors
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using beta-blocker medications for high blood pressure or performanceanxiety have later found them useful for assessing investments. Beta block-ers can allow a measure of detachment from the worries of the crowd.Selective serotonin reuptake inhibitors (SSRIs) have been used by CEOsfor reducing their anxiety in leadership roles. One trader I described tooklithium for bipolar disorder and self-modiﬁed his dose in response to hisneed for a few days of quick thinking, late-night working, and creativity.Personally, I don’t endorse medications for improving investment decisionmaking.
Illicit substances that some investors use to self-medicate, such as al-cohol, cocaine, and amphetamines, often result in worse long-term out-comes. Traders who decompress after a day’s work with a glass of beerare chemically dampening their anxiety and hypervigilance from a dayon the job. Unfortunately, the alcohol disrupts their rapid eye movement(REM) sleep, leading to easy cognitive fatigue and slightly impaired judg-ment the following day. Traders who use stimulants (such as cocaine oramphetamines) at work are enhancing their dopamine function and in-creasing their conﬁdence, but they may be dosing incorrectly and are atrisk of addiction and permanent adverse events.
One professional poker player gamely reported that taking prescrip-tion amphetamines (Adderall) had helped him earn millions of dollars byincreasing his alertness after long hours of play, relative to other players.Increased alertness is useful in cognitively exhausting games such as pokeror chess, especially if one’s opponents are unmedicated, but beneﬁts for in-vestors are unlikely.
SELF-DISCIPLINE
“Self-discipline is the single most important suc-cess factor. Without it, nothing else matters.”
—Howard Fleischman, PhD, performancepsychologist
Self-discipline is a personality trait that varies across individuals. Im-portantly, one’s degree of self-discipline correlates with wealth level. Ingeneral, pursuing immediate gratiﬁcation erodes prosperity. Self-disciplineis a prerequisite to performing any of the self-help exercises in this book.Before embarking on a path of personal change, be sure you have the innermotivation to begin, the personal curiosity to explore, and the discipline tostay with the work when it becomes challenging. If you falter, then beginagain.
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Investing “rules” are useless for people who don’t ﬁrst have discipline.In fact, without discipline, one should stay away from any type of active,strategy-driven investing. So how can those who are undisciplined becomemore organized?
The essence of self-discipline is emotion management, which is differ-ent from emotional control. Management focuses on awareness and redi-rection rather than confrontation and repression of emotion. The internaltension resulting from the confrontation with and repression of undesiredfeelings strains cognitive resources. At the turn of the nineteenth century,Sigmund Freud even theorized that the repression of emotions was the rootcause of mental illness. Redirecting strong emotions towards productiveoutlets is important for maintaining personal happiness and harmoniousrelations with others.
Self-discipline does not refer to a rigid adherence to an investmentstrategy, but rather to a focused and organized mind-set about examin-ing investments. Many investors have inadequate experience and educa-tion with the markets to understand proper boundaries and the role ofﬂexibility.
Traders such as “Stock Market Wizard” Mark D. Cook have learnedto use emotional awareness and self-discipline to their advantage. Cook isconsidered one of the most successful short-term traders in history. Cookremarks, “Whenever I am most fearful of the market, that emotion helpsme decide to go long and buy. . . . Whenever my fears become overwhelm-ing, my discipline tells me to buy and discipline must win out or you aredoomed to failure.”15 It is not only important to identify one’s emotionalimpulses, but Cook actually uses those impulses as contradictory tradingsignals. He summons enough courage to do the opposite of his strong emo-tional drives.
Techniques for enhancing one’s level of investing self-discipline are
outlined in Table 21.1.
With a balance of self-discipline and cognitive ﬂexibility, rules can beapplied to enhance performance without inducing excessive rigidity. Short-term investors and traders will especially beneﬁt from the following ideas,but analysts and portfolio managers can use them as well.
1. Start every day fresh. Options specialist Richard Friesen, no matterwhat his recent performance had been, reminded himself daily that riskswere lurking in the markets by thinking: “There’s a bullet coming towardmy head today, and I’ve got to ﬁgure out where it’s coming from and howto stop it.” This mantra brought down overconﬁdence, instilled humility,and encouraged preparedness.
2. Invest an amount of money that’s comfortable. If you are fearful orexcited about the money you have on the line or what you stand to gain
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TABLE 21.1 Identifying the Emotional Precipitants of Lapses in Self-Discipline
Self-Discipline
Questions to Diagnose Lapses
Self-Awareness
What feelings compel you to break your personal rules? Is this apattern for you? What are your reasons or rationalizations?
PerspectiveCourage
What do you stand to lose by exercising self-discipline?What has prevented you from creating a strategy or disciplined
mindset? What are the tough issues you’d prefer not toaddress?
Structure
Can you design a program of analysis that ﬁts well into your
strengths but does not overlook other key factors?
from a trade, then your judgment will be useless, and you’re not goingto think clearly. Don’t invest more than you can tolerate losing. Whenemotions become overwhelming, “throw a maiden in the volcano.”3. Plan and anticipate, don’t react. Market Wizard Linda BradfordRaschke counsels, “Know what you are going to do before the marketopens.”16 Mark Cook remarks, “Planning is the objective part of trading.Start with the worst case scenario and work from there. . . . Once youare in a trade, emotions take over, so the plan must be in place beforethe activity takes place.”17
CREATING A DECISION JOURNAL
Some researchers believe that traders can learn to behave more rationallyby recognizing and learning from their past mistakes. Journaling is themost commonly prescribed method. Documenting both the assumptionsthat drive decisions and the resulting consequences of those decisions pro-vides valuable insight into patterns of strength and weakness in judgment.A psychological decision journal should follow a format approximatelylike that in Table 21.2. The format should be modiﬁed to ﬁt your speciﬁcdecision process. As trading psychologist Brett Steenbarger points out,keeping a decision journal is an important part of a trader’s daily trainingand practice. While athletes exercise their bodies and hone their physicaltechniques, investors need to be aware of defects and advantages intheir mental game.18 While the journaling process may seem excessivelycumbersome and time consuming, consider that physical athletes mustspend hundreds of hours in practice and training for each hour of actualcompetition. If you have difﬁculty following such a template, then simplifyit until acceptable.
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TABLE 21.2
Questions that May Help in the Development of a PsychologicalDecision Journal (should be supplemented by a quantitative journal)
Psychological Decision Journal: Ask Yourself These Questions and DocumentYour Responses.
Predecision
What are my qualitative reasons for investing in this security?
Postdecision,
Pre-outcome
Postoutcome
Prioritize and list them in order of importance.
How am I feeling about this investment?What is my level of conﬁdence in this decision?What is my advantage?Why have others not identiﬁed this opportunity?What objective changes in conditions will change my decision?What are my speciﬁc sell criteria?Am I doubting or feeling anything about my decision?
Was it an accurate decision?Were there any ﬂaws in the judgment or decision-making
process?
Can I ﬁnd any patterns that this decision shared with my
previous decisions?
Did I deviate from my investment philosophy?What were the most successful aspects of this decision?
After monitoring dozens of decisions, it is helpful to review the datayou gathered. Look for patterns in your feelings and decisions. Becausefeelings distort how we evaluate information and assess consequences, ob-serve whether your feelings had anything to do with your judgments.
This psychological decision journal template should be used as acomplement to a standard spreadsheet format with quantiﬁable statisticssuch as style of trading (swing trade, day trade, long-term position in-vestment), stop boundaries (both time and price), and objectives (price,news, time, or fundamental value). Important data to measure includeyour expected risk/reward probabilities (based on historical analysis), ex-pected and actual proﬁt/loss per trade, number of long and short trans-actions, number of winning and losing trades, time spent holding losingtrades versus winners, and the proﬁtability of strategies in different marketenvironments.19
Biases can be detected not only in your responses on the psycho-logical decision template, but also in the statistical data. For example,by comparing the duration of winning and losing positions, one can ﬁndevidence of loss aversion (holding losers longer than winners). Havingmore winning trades during bullish or bearish markets may indicate that
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one’s strategy or decision process is biased towards periods of favorablesentiment. Whatever the bias, it will remain problematic until it is draggedout into the light of day.
The next chapter discusses more involved strategies for psychologicalmanagement when dealing with losses, fear, or stress.
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C H A P T E R 22
ChangeTechniquesGoing Deep
“[Proﬁtability] comes when the investor realizesthat investment success does not come from exter-nal control, but from internal control.”
—Van K. Tharp
T his chapter deals with techniques for minimizing excessive risk per-
ception, stress, and anxiety. An entire chapter is needed about theseemotions because they are the chief result of activation in the brain’sloss avoidance system and probably the leading cause of investing errors.These emotions drive such individual and collective investor mistakes asthe disposition effect, the equity premium puzzle, overestimation of lowprobability risks, and market panics. Collectively, emotions generated bythe loss avoidance system affect perception and pricing of securities, lead-ing to some of the best opportunities for courageous investors (as ex-plained in the next chapter).
Theoretically, it should be relatively straightforward to minimize theseemotions. Unfortunately, pain and potential loss activate automatic neuralprocesses. They function beneath conscious awareness, and it is very dif-ﬁcult to avoid their inﬂuence. Research cited in this book documents thateven professional traders and investors are susceptible to loss aversion andthe disposition effect (holding losers too long). It appears that experience,even with frequent performance feedback and ﬁnancial incentives, is inad-equate to entirely eliminate biases originating in the brain’s loss avoidancesystem.
In fact, biases such as loss aversion are exacerbated by market losses.For example, in Professor Baba Shiv’s $20 coin-ﬂipping experiment with
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brain-damaged and normal subjects (see Chapter 15), the normals’ per-formance actually deteriorated over the course of the experiment. Partici-pants became more irrational, abstaining from the gamble more frequentlyand making less money over time.
Loss avoidance mistakes are very costly in terms of lost returns, sohow can they be reduced? A number of investment advisers have ap-proached me with a question: how can they sell risky products to theirclients when they know that their clients will be angry and bail out afterone quarter of underperformance? It is difﬁcult for them to watch theirclients’ wealth stagnate in cash accounts, but they know that their clientsmight be too nervous if they own more stocks.
Education and experience should be the best techniques for reducingthese investors’ biases. Education is useful, but it is also intellectual, anddoesn’t connect with their anxiety during a down quarter. Deeper psycho-logical techniques, which are outlined brieﬂy in this chapter, are likely tobe helpful for excessively risk-averse investors and clients.
DEALING WITH FEARFUL ANDOVERCONFIDENT CLIENTS
For investment advisers who have had no training in working with anx-ious clients, the experience can be aggravating. During market downturnsis when the truly anxious and risk averse clients become apparent. Someadvisers have mentioned to me that they cannot believe their clients’ re-sponses on risk tolerance questionnaires. Many clients think they can han-dle volatility, but when it happens, they become panicked. Advisers havejokingly mentioned that the frequency of worried client telephone calls totheir ofﬁces is a contrarian market indicator.
So what can advisers do to calm their stressed-out clients? There aremany techniques, such as full accommodation with their wish to sell, re-questing to sell a small part of their position to relieve the pressure (“throw-ing a maiden in the volcano”), or a conversation which attempts to calmtheir loss avoidance system and help them retain a long-term focus. I’veprepared a script that ﬁnancial advisers can use with worried clients dur-ing volatility (see Table 22.1). I use the acronym “IDEAS” so that thescript can be easily remembered. The same script can be modiﬁed to helpmanage client overconﬁdence, as seen in the secondary examples in thetable.
If you are an investment adviser, you will want to alter the dialogue toyour needs, but the gist of the table should apply to most emotion-loaded
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TABLE 22.1
Script that Can Be Used with Fearful or Overconﬁdent FinancialPlanning Clients (IDEAS)
Ideas
Steps to Take
Example Questions for Fearful (F) andOverconﬁdent Clients (O)
I
D
E
Inquire how they are
(F): “How are you doing with the market action
doing.
lately?”
Describe what youheard them say.(Called mirroringor reﬂecting.)
(O): “Have you been following any particular
stocks lately?”
(F): “Okay, so you’re uncomfortable with the
volatility.”
(O): “Okay, so you’re excited by the prospects of
Nanotech stocks.”
Empathize with their
(F): “Naturally it’s diﬃcult for you to watch your
feelings.
A