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Cook`s Kitchen

In part 1 of this series, we looked at two areas of proof that explain why traders must have a system to achieve consistent profits over the long-run. We continue today with two more fact-based arguments from science.

My arguments might be considered a little too academic by some traders. Again, if you are already well-convinced of the reasons you need to be systematic in your trading, maybe you don't need to hear this logic. But I encourage you to dive in because this article will still entertain, enlighten, and fortify your knowledge.

In part 3, after we discuss the final proof that comes from gambling houses, I will profile several ways to systematically use the Zacks Rank as the foundation for your stock trading campaigns.

The Proof from Science

In the late 1960's, psychologists Daniel Kahneman and Amos Tversky began a series of research experiments that would start to form a body of knowledge we now call behavioral finance.

Not interested in what people "felt" or "thought" about their experience, the two set out to discover how people actually made decisions when faced with a variety of specific challenges of uncertainty and risk modeled on daily life.

What they consistently found is that people are consistently irrational when dealing with money and risk-reward scenarios. Typical experiments were constructed so that participants were given the same basic financial or other risk decisions, but with different "framing."

In other words, how the question was asked seemed to make all the difference, especially if people had to think about preserving gain vs. avoiding loss.

Much of their research resulted in the general conclusion that most people rarely follow rational rules for managing risk and uncertainty. When faced with protecting guaranteed gains, people become risk averse; but when faced with avoiding a certain loss, people will often take bigger risks.

This "natural irrationality" is the antithesis of skills required to make money in short-term trading where the "golden rule" is to cut your losses short and let your winners run.

How I Became Addicted to the Science of Trading

As a high-frequency interbank currency trader for most of the last decade, my spare time was filled with a passionate pursuit to discover the secrets to short-term trading success. As you know from the first article in this series, I read and re-read the Market Wizards books by Jack Schwager. I also read the works of Dr. Van Tharp, the psychologist and trading coach profiled by Schwager.

In 2004, I developed a 3-hour probability and risk seminar to teach traders about the treacherous twins of market speculation -- randomness and ruin. I also wrote an 8,000 word paper titled "Your Brain Wasn't Made to Trade" to highlight what traders could learn from Kahneman and Tversky and from brain science.

In 2008, I published a shorter version of that paper in SFO Magazine, just focusing on the behavioral finance aspect. I opened the discussion with a look at "rogue" traders because I believed that what a Bernie Madoff does to a billion dollars of other peoples' money, we do to our own accounts when our psychological biases and "frames" are not transparent to us and reined in.

And you may have noticed from the timeline, that I wrote these things before Mr. Madoff "made-off" with billions of OPM. My story line has not changed: this will happen over and over again because human nature never changes.

Here's a classic problem from the work of Kahneman and Tversky that I used in the article "Mental Models of Financial Sabotage."

Two problems and their results show how inconsistent and irrational people can be about probable outcomes. Answer them yourself, one at a time.

Problem 1: You have just been given $1,000 and must choose between the following options:

A. A sure gain of $500.

B. A 50-percent chance to gain $1,000 and a 50-percent chance to gain nothing.

Problem 2: You have just been given $2,000 and must choose between the following options:

A. A sure loss of $500.

B. A 50-percent chance to lose $1,000 and a 50-percent chance to lose nothing.

What did you choose for each? Do you recognize that the two problems are identical in terms of probable net cash? You either accept a certain $1,500 with options A or you gamble on a 50/50 bet of ending up with $1,000 or $2,000 with the B options. The only difference between the two is how they are framed. One is presented in the context of how much you gain, the other in terms of how much you lose.

What Kahneman and Tversky found was that 84 percent of subjects chose A for problem 1 and 69 percent chose B for problem 2. Their conclusion: Based on these results and those of dozens of other similar experimental problems, people have a strong bias to avoid any amount of loss, regardless of risk (50/50 chance of losing half), and they will prefer a certain gain over a random, coin-flip gain of twice as much.

This is Your Brain on Nasdaq

The other body of science that proves people need systematic decision-making frameworks to handle risk and uncertainty is that of neuroscience. The human brain is an amalgamation of structures and functions evolved over hundreds of thousands of years, tied together with a web of communication networks that makes the Internet look primitive.

Not only that, but there are over 100 specialized chemical hormones traveling at high-speed on that network to carry out instructions and responses in your body and consciousness.

Nobody really thinks of him or herself as a bag of neurons and chemicals, driven by impulses and unconscious emotion. But what escapes most of us is the fact that we are not as simple as the personality, beliefs, values, and experiences we think we have and that we perceive as making us who we are.

You may think of yourself as having a single "identity" or personality, but there's a lot more going on under the surface that can interfere with the sound decision making you believe is coming from your conscious mind. I call this your "multi-mind."

Your brain, as a multi-dimensional hodgepodge of evolution, is really a complex collection of competing drives and forces, trying to find some form of balance and comfort in a stressful, uncertain world. We say we want one thing and we do another. We often act irrationally, against our own best interests, and sometimes very self-destructively -- especially when it comes to money and risk.

Train Your Brain, or Burn Your Money

You only need look at Wall Street, littered with rogue traders, con men, and big bets that take down 100-year old banks, to see how humans typically handle money and risk. Most of us are not fraudulent thieves and would never think of stealing or ruining another’s fortune.

But I'll say it again because it's all you need to remember to understand what I am talking about: what the rogue trader or Bernie Madoff does to a billion dollars, we do to our own accounts all the time.

We are hard-wired to be defensive, egotistical, greedy, and fearful. This is how our brains evolved to survive in simpler times when laws of predator and prey ruled. You will not be surprised to hear that these are some of the worst qualities in a trader.

They are what make your money go away from you in the markets. It's why I say "your brain wasn't made to trade."

And this is why successful traders, money managers, and trading coaches will tell you the number one challenge in becoming a successful trader is dealing with your mind and emotions.

The discipline of top traders does not come naturally to us and the mental-emotional requirements of successful trading are way beyond the average stress level of most occupations precisely because of the need to make rapid decisions about two very emotional topics: our money and our egos, i.e. being "right" vs. being wrong.

Here's to your ability to control your mind and ego systematically so that your money stays with you and tends to attract more of its kind over the long-run. See you next time in Part 3.

If you want to read my article at SFO Magazine, go to www.SFOmag.com and sign up for a free subscription. There you will also find my book review of Taleb's The Black Swan, which is a related theme in our ability to make money disappear at the institutional level using models. My article on options put-call parity is also there.

Kevin Cook is a Senior Stock Strategist with Zacks.com

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