Welcome back to Mind Over Money. I’m Kevin Cook, your field guide and story teller for the fascinating arena of Behavioral Economics.
This episode is all about the risk-reward mechanics of decision-making. Sometimes we avoid making decisions, and often we never learn from our bad ones. I was fortunate that I became a high-frequency currency trader some 20 years ago and learned how to make lots of decisions every hour that I could never afford to regret, and only learn from.
But that doesn’t mean I don't still fall prey to the bad habits we all have when faced with uncertainty and risk.
Did you ever wonder how great investors and traders make decisions that put them consistently ahead of their peers?
I do not put myself in the category of greatness, but I know a little about those who belong because I’ve spent considerable time in the past two decades studying great short-term traders and great long-term investors.
Now in finance, you always have to be careful when talking about success to make sure you are not just high-lighting the survivors. Since there’s always a winner, we have to make certain we are looking at credible degrees of success, over time, that go beyond mere randomness.
When I studied short-term traders in the 1990s in the commodity and currency pits of Chicago, and read about them in Jack Schwager’s Market Wizards book, I came away with six pillars of behavior that seemed to make all the difference over time and across markets. They were...
1) Psychology: not just awareness of bias and decision-making, but continuous process improvement.
2) Probability: without sound mechanics of situational risk and reward, it’s way too easy for emotions and bias to take over.
3) Systems: not just a computer that spits out signals, but systems for everything from your research process to performance evaluation.
4) Risk Management: precise rules for capital allocation and preservation are crucial to long-term survival.
5) Discipline: speaks for itself, especially if making dozens of decisions per day that require consistent rule-following.
6) Consistency: can you run all these processes for years and survive the vagaries of changing markets and seasons?
What happens when a trader or investor doesn’t try to master these principles and skills? At worst, they lose all their money quickly. At best, they might get lucky and survive, but not for long.
And in the middle is the majority that slowly watches their money bleed away a little every week, sometimes in bigger chunks.
When I saw how hard it was to apply these principles in the chaos of markets, I looked to two different sciences to help explain it. Behavioral finance, spear-headed by Nobel prize winner Daniel Kahneman,looked at human decision making under uncertainty and risk with experiments to find out what do most people do in a given situation.
I say that these researchers study us from the “outside-in” to explain behavior. And the neuroscientists, of course, study us from the “inside-out” to explain our actions.
After I read as much of the important research from both sciences as I could handle, I came up with a stunning conclusion: Your Brain Wasn’t Made to Trade.
And it fit with what evolutionary biologists and anthropologists were teaching us about what kinds of brains a few million years of “fits and starts” from natural selection gave us. They definitely weren’t made for staring at prices moving rapidly up and down and changing our wealth outlook by the second.
How do I know? Because most of us naturally do exactly the wrong things, especially in short-term trading. We hold on to losing trades and we take profits too soon. This, is the mathematical recipe for making your money go away over time.
In trading, the Golden Rule is “Cut thy losses short, and let thy winners run.” But most human traders (and monkeys) do exactly the opposite as fear, greed, illogical biases and ego take over, and we make our money go away from us.
We assume we can make rational decisions about our money that are best for the long-term, but that is a big assumption. Most of us are very irrational when it comes to every day money/risk decisions and long-term planning ones.
I covered much of this in my March 21, 2017 episode “Irrational Demands: Of Anchors, Pearls, and Procrastination.”
Well, back in 2004, I was pretty proud of my original idea that Your Brain Wasn’t Made to Trade.
Then I remembered a book I had read in 1990 that probably helped me along this path. New World, New Mind by Robert Ornstein and Paul Ehrlich, the former a neuropsychiatrist and the latter a biologist who was famous for some of his alarming calls about over-population back in the 70s and 80s. Their book proposed that...
The evolution of our brains, and our ability to sense cataclysmic change that takes place over long periods of time, is simply not going fast enough. The only thing that can make a difference is accelerated cultural evolution.
Here’s how one bright observer, who reviewed the book on Amazon, described it...
"One of the more compelling points the authors make is that not only are politicians being elected and rewarded on the basis of short-term decisions that are by many measures intellectually, morally, and financially corrupt, but the so-called knowledge workers--the scientists, engineers, and others who should be "blowing the whistle," are so specialized that there is a real lack of integrative knowledge."
Can you think of some areas – besides the obvious climate change debate – where short-term thinking blinds us to long-term effects and changes?
I think of education vs. the entertainment machine where parents are far too likely to let their kids have electronic gadgets, TVs, and phones to babysit them because mom and dad have stuff to do, or both parents work.
Another is the nuclear arms race which seemed to be a problem that got put on ice in the 1990s and now with North Korea rattling their sabre this month, we feel that old question again “Could it really happen?”
This is one of the biggest examples that Ornstein and Ehrlich highlighted in New World, New Mind. I can’t remember exactly how they framed the problem or their solution – other than new cultural and political institutions that move beyond warfare as a primary solution -- but the first thing that comes to mind for me is that if some of us are more irrational than others, why do we sleep tight thinking we can prevent nuclear war when just about any very lucky idiot could get his hands on a missile?
That’s scary stuff. And we can’t say for sure we’ve figured out a good solution just because we’ve gone 60-some years without incident. Our stone-age brains can barely comprehend that kind of cataclysm. So it’s easier not to think about. But Ornstein and Ehrlich thought we should try anyway.
If you think I have a solution, I don't. But I am an eternal optimist and so in the rest of this episode of the Mind Over Money podcast, I share a book by another dynamic duo who 25 years later care about our fate – and science – just as much as Ehrlich and Ornstein.
I also break down this week’s big trading in “immuno-oncology” stocks such as Kite Pharmaceuticals , which was bought by Gilead Sciences (GILD - Free Report) for $12 billion and caused a feverish rally in related peers like Juno Therapeutics (JUNO - Free Report) and bluebird bio (BLUE - Free Report) . I tell you how I’m playing these stocks and whether or not Celgene (CELG - Free Report) might be the next bidder for a little biotech wonder.
Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the Healthcare Innovators portfolio.