confirmation biases: Traders tended to read posts that most agreed with their views. Interestingly, those with greater confirmation bias also displayed greater overconfidence in their ideas, tended to trade more often, and tended to lose more money than did peers with lesser conviction. Scott, Stumpp, and Xu reviewed the literature in 2003 and concluded, “A considerable amount of research suggests that people are overconfident, and that investors in particular are overconfident about their abilities to predict the future” (p. 80). Moreover, they found that such overconfidence biases are present across a variety of markets and countries.
Nor is overconfidence limited to the trading world. In their book, Decisive (2013), the Heath brothers echo this conclusion, offering a perceptive quote from Daniel Kahneman: “A remarkable aspect of your mental life is that you are rarely stumped” (2011, p. 2). They suggest a number of strategies for overcoming overconfidence biases, including multitracking (entertaining multiple alternatives) and actively considering the opposite sides of our beliefs. The common element among these strategies is cognitive flexibility. Once we are not locked into particular ways of seeing problems – that is, when we are no longer functionally fixed, like the subjects in Dunker's study – we can make better life decisions. We cannot pursue an alternative future unless we first can envision alternatives.
It is ironic, then, that so many traders – and even trading coaches – insist that we should trade our convictions and increase risk-taking during times of high conviction. Anyone following that advice is likely to take the most risk when they are most overconfident. And all too often that's exactly what happens: Locked into large positions with über-confidence, even flexible traders become inflexible, punctuating winning periods with outsized episodes of drawdown.
Key Takeaway
If your risk-taking mirrors your level of conviction, you will always be most vulnerable – and least able to adapt to changing markets – when you are most overconfident.
Take the case of Joe, a prop firm trader who contacted me following a prolonged period of losing performance. He had been trading stock index futures successfully for several years, but now found that his bread-and-butter trades were not profitable. Specifically, when he left relatively large, resting orders in the book, he found that these were invariably hit, with the market then trading quickly against him. “You can't win,” he lamented in our initial talk. “If you don't get filled, you missed the move. If you get filled, you don't want 'em!” It felt to Joe as if someone secretly knew his positions and was pushing the market just beyond his point of tolerance. Of course, someone did know his positions: Market-making algorithms, continually monitoring and modeling the order book, could rapidly detect supply/demand imbalances and exploit them on very short time frames. A large resting order – in Joe's case many hundreds of ES contracts or more – was a sitting duck for sophisticated market makers.
A trading coach Joe had previously contacted had suggested that the problem was that Joe was not differentiating his higher conviction trades from his lower ones. If he were to clearly identify the confidence he had in a particular trade and predicate his level of risk-taking on his conviction, he would avoid lower-probability setups and maximize his performance on the higher-probability ones. It sounded good in theory, but worked poorly for two reasons. First, his increased size in his high confidence views led to even greater visibility and vulnerability in the order book. As a result, when I conducted a historical analysis, I found that his hit rate and overall profitability were lower for his identified high confidence ideas than for his more marginal trades. The second problem was that Joe was most confident when he was on a run. As a result, he would make money on one small trade, then another, then another, and then really size his positions only to have them picked off and wipe out his prior gains. At one point, the coach urged Joe to not lose confidence in his judgment: “You have to be in it to win it!” But it was precisely when Joe was in it that he was losing it.
My analysis showed that when Joe's orders or positions reached a certain percentage of the average one-minute volume trading at that time, the odds of his trades moving against him increased dramatically. During periods of high volume and high liquidity in the book, his trades – even larger ones – were more likely to be profitable. The solution to his problem had nothing to do with conviction – or even psychology. Quite simply, Joe needed to adapt to the new market-making regime and achieve more optimal execution by distributing his orders over time with as little visibility as possible. The change that Joe needed to make was not a psychological one; like Emil, our restaurant entrepreneur, he needed to engage the marketplace in a different manner.
So why is there such an obsession with “conviction” in the trading culture? Very often, the focus on conviction keeps people from pursuing change. After all, why do anything different if you're convinced what you're doing is fine? Imagine a soldier scouting enemy terrain. The odds are good that he will not operate on the premise of conviction. He will move differently through forests and fields; he'll treat every building as a source of potential threat and will remain ever-vigilant for explosive devices. In a changing, dangerous environment, conviction gets you killed. We can only glorify confidence in trading if we cease to view markets as dangerous environments – itself quite an act of overconfidence.
In part, our focus on conviction as a success driver may simply reflect the cognitive consequences of survivorship bias. In any group of traders, the ones who lead the pack in absolute returns will almost certainly be high risk-takers. Now, of course, the cohort of worst-performing traders will also include the high risk-takers. After all, few market participants blow up their books on small bets and low conviction trades. But if we're looking for the successful market wizards, we'll usually identify those who have made the most money and, if we talk to them, we'll generally discover that they went all-in on at least some of their trades. That hindsight perspective easily leads to the assumption that a defining element of trading success is supreme confidence and risk taking.
The problem is that supreme confidence rarely permits supreme flexibility. In previous writings, I've mentioned research pertaining to positive attribution biases. We tend to attribute positive outcomes to ourselves and negative outcomes to situations. So, for example, we're likely to pat ourselves on the back for a good market call when we make money, but complain about rigged markets when we're losing. Similarly, we tend to view ourselves in an unusually favorable light when we compare ourselves with others. A favorite exercise for a medical student class I taught asked the group to evaluate themselves relative to their peers on such adjectives as “caring” and “motivated” using a five-point scale, where 1 = much below average; 3 = average; and 5 = much above average. As you might guess, very few students rated themselves as average or below; consistently, 90 percent of the group deemed themselves to be better than average!
When I've given the exercise to groups of traders, the positive attribution bias has been every bit as clear. Most traders rate themselves as above average in ability, despite results that generally don't support such a view. When asked about the discrepancy between their self-perception and their actual trading performance, they cite their potential, their recent improvement, situational influences hampering performance, and the like. The problem is that traders who overrate their abilities are not likely to be proactive in recognizing the need to adapt to shifting market conditions. Joe viewed himself to be a very successful trader and attributed his recent poor performance to a “slump.” That led him to seek help with his psyche, though what he needed was a way of adapting to an altered market-making environment. But the same overconfidence bias that can affect single trades can threaten trading careers. Belief in oneself is necessary for success; flexibility in self-belief is necessary for ongoing success.
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