fast and slow thinking in myriad ways. At one extreme, we have the daytrader, who performs relatively little deep analysis, but who can excel at real-time pattern recognition. At the other extreme, we have the long-term equity investor who studies companies in depth and constructs complex portfolios that hedge various sources of factor risk in order to profit from the price movements of strong versus weak companies. In between these two are hedge fund managers that combine the deep dives of macroeconomic analysis with the quick processing of market trends and reversals.
My experience is that successful market participants rarely excel in both slow and fast thinking, but they almost always excel in one or the other. If you look at what makes them successful, what you find is that they discover ways to engage markets that leverage either their fast processing or deep thinking skills. In a purely cognitive sense, they play to their strengths. This was certainly true of Maxwell: His scalp trades were the result of considerable fast thinking skill.
Slumps follow when traders respond to market setbacks by switching cognitive modes. The fast thinker begins to overanalyze markets and loses further touch with markets. The deep thinker becomes fearful of loss and acts on short-term price movement. Anxiety and performance pressure take traders out of their cognitive zones – and away from their strengths. So it was for Maxwell. His setbacks began in low-volatility markets that were increasingly dominated by market-making algorithms. He convinced himself that he needed to adapt to these changes by widening his holding periods and trading more strategically than tactically. Instead of following the market tick by tick and gauging order flow, he looked to longer term support and resistance levels on charts and ideas coming from earnings reports, data releases, and recent news. All of these took Maxwell out of his zone: He was trying to adapt to change, but doing so by becoming less of who he was at his best. Fortunately, his scalp trades kept his fast thinking skills alive – and his trading account treading water – during this wrenching period of adjustment. Over time, however, his results were becoming more average because he was increasingly relying on his relatively average deeper, analytical skills.
What turned Maxwell around psychologically, however, was that he redefined his emotional commitment to trading. Recall Chris and Gina. What was their prime motive? They wanted to be great parents and provide their children with the kind of upbringing they never had. They could not change their marriage until they reached the recognition that they couldn't be good parents to their maturing children unless they modeled a good marriage. Now their motives were aligned. They practically leaped into enhancing their marriage because they were doing it now for a good cause.
Maxwell's psychological raison d'être was that he was the smart guy who profited from the idiocy of others. Making money for him was an emotional affirmation that he was clever, unique, and distinctive. When he stopped making money – and especially when he saw market makers profiting at his expense – he began feeling like an idiot. So what did he do? He tried to make himself into a deep thinker, someone who would be smarter than others in a different way. Ironically, he was seeking affirmation by running from his strengths.
What the solution-focused exercise demonstrated was that Maxwell was successful in a number of his trades, but that he was successful by being more tactical, not by becoming a grand strategist. As with Gina and Chris, Maxwell embraced his strengths in spades once he realized that they were the path to his emotional success. A kid from the proverbial wrong side of the tracks, Maxwell had a bit of a chip on his shoulder. He was out to prove himself to be worthy. That emotional priority wasn't going to change. We just needed to align that priority with his best trading. That became much easier when Maxwell was able to see that, in trying to predict markets, he was being one of the idiots he routinely ridiculed. He was no more willing to be an idiot than Gina and Chris were willing to be bad parents.
I won't pretend that the work with Maxwell was easy. The turnaround did not occur overnight. A great deal of work remained to distinguish why some of his tactical trading based on pattern recognition worked some of the times and not at others. It turned out that further investigations of his trading were needed. What I found in breaking down his trades was that he was losing more on the short side than the long side – and this was in markets that had been in longer-term uptrends. Subtly, Maxwell was trying to prove himself by making himself into a contrarian. When he saw that this also was acting like an idiot by swimming against the tide, he became much more open to using simple gauges to stay on the proper side of the market. For example, he defined strong, neutral, and weak markets based on early readings of how the market traded relative to its volume-weighted average price (VWAP), preventing him from fading the very strong and weak markets. By expanding the useful patterns he looked at, he was able to leverage his pattern recognition strengths.
He came to me with problems, but it was his good trading that generated the solutions. Once Maxwell found a way to bridge his fast trading skills with the emotional driver of his trading, meaningful change could occur.
That is the takeaway: We cannot change if we fail to tap into those emotional drivers.
The Perils of (Over)Confidence
We know how to plan for change in our trades. So why do we rarely get to Plan B in our careers? The cases of Chris and Gina and Maxwell illustrate that our core motivations and commitments can lead us to act in ways that are ultimately self-defeating. Years ago, I worked with a very successful professional who experienced considerable rejection both in childhood and later in a bad romantic relationship. She developed a commitment to self-reliance, determined that she would never be hurt and vulnerable again. As a result, she moved forward rapidly in her career – and she remained lonely, unable to sustain long-term relationships. Her commitment to independence made it difficult to sustain emotional commitments. That couldn't change until she recognized, in her own experience, that she could depend on someone she cared about and still remain independent. A turning point in her therapy occurred when she did not perform a homework exercise I had suggested. It took a while to get her to acknowledge that she was uncomfortable with the exercise and didn't want to go down that path. Instead of exploring her “resistance” to the exercise, I congratulated her on standing her ground and acting on her instincts. We then jointly crafted a different exercise.
What helped spark the change was a relationship experience. She could depend on me —and be independent of me. Sometimes change begins in small ways, in a single situation, a single relationship. And many times it begins in ways other than talk.
It takes a while to get to the change point, however. Those anomalies – the consequences of doing the right things and now getting the wrong results – typically have to accumulate before we contemplate doing something different. It took that young lady quite a bit of loneliness before she was willing to reach out to a counselor she could rely on. After all, when our approach to life or trading pays off in the present, we build confidence in what we're doing. That confidence can become overconfidence. We behave as if we've found a permanent life solution, as if we can continue on in our present mode and never get hurt again: never live in a troubled household, never have another losing year. Maxwell wasn't just confident about his trading during his money-making years; he was so confident that he felt no need to analyze his wins and losses or adapt to changing market conditions – until the profits stopped rolling in.
Author Robert Anton Wilson has noted the similarities between those who are totally convinced and those who are totally stupid. He also pointed out that our convictions make us convicts: We become imprisoned by our belief systems. As we saw earlier, a trader with absolute conviction in a statistical model could face quite a loss when the present idiosyncratically deviates from the past. Commitment looks like admirable discipline – until it becomes a straitjacket.
Behavioral finance research finds consistent confirmation and overconfidence biases among investors and traders. A confirmation bias occurs when we selectively process information that supports our views. Overconfidence biases lead us to overestimate the odds of an anticipated trade or market scenario working out. An interesting study of South Korean investors from Park and colleagues looked
