envision its use as a candle holder. They were trapped, it seemed, in their mental sets.
Now here's the interesting part: Subjects facing the exact same candle problem but initially shown the tacks outside of their box had a much easier time solving the problem. Once the box was separated from its contents, it was not difficult for the study participants to perceive alternate uses for the box. Instead of seeing it as a container for tacks, they perceived it as an empty box. With a different perceptual frame, subjects were no longer functionally fixed and could shift their mental set and solve the seemingly unsolvable.
In our story of Emil the chef, it's clear that he succeeded, not by improving the old restaurant, but by shifting his mental set and redefining the concept of restaurant. The functionally fixed previous owner might have tried a host of menu and décor changes to no avail. As long as he stuck with the old definition of restaurant, he was bound to thwart the desires of the new generation of diners.
Emotional fixedness fuels functional fixedness. When we identify with a way of trading or a kind of analysis, we not only can't perceive alternatives: We typically don't want to see them. Many years ago, I spoke with an equity long/short money manager who was struggling with performance. He viewed himself as a master stock picker based on his ability to identify value that was underpriced by the market. This value orientation made him a contrarian: He liked good companies that were unloved by the Street. The problem was that unloved companies often became more unloved before the market awarded them the expected premium. The stock that was a great buy 20 percent off its highs became a burden to the portfolio once it was 35 percent below its peak. That led to agonizing decisions about selling good companies at bargain prices versus holding losers and risking poor performance and investor redemptions.
I suggested to the manager that his dilemma might be addressed by creating a relatively straightforward money flow filter for the names in his book. I showed him how each transaction in each stock occurred either nearer to the best bid price at the time or the best offer. This execution information, summed over time, could provide a useful indication of the degree to which buyers or sellers were accumulating or distributing their shares with urgency. By waiting to size up positions in his fundamentally strong stocks until they were showing early signs of accumulation, the manager could potentially limit his drawdowns and more effectively leverage his bets.
The manager looked at me in total shock. It was as if I had suggested that he solve his domestic problems by initiating an extramarital affair. “But I'm a stock picker,” he explained. “That's what I do best. If I start doing something different, I'll never succeed.” For him, stocks traded on fundamentals like boxes hold tacks. He was functionally and emotionally fixed: Any analysis that did not pertain to company fundamentals was suspect. From my perspective, a money flow filter for his risk exposure could have made him a more effective fundamental stock picker, just as the social focus made Emil a better restaurateur. But our manager did not want to track money flows and refine his entry execution; he wanted to outsmart the market and find unrecognized value. In a very important sense, he was looking for self-validation, not profit maximization. And that is a powerful barrier to adaptive change.
The Power of Flexible Commitment
Antti Ilmanen's Expected Returns text is noteworthy for its conceptual framework. In the book, he breaks markets down into “building blocks” and explains returns in terms of the interplay of these drivers. As an active trader, I look at different building blocks than Ilmanen, but the structural approach is similar. Starting with the vast array of technical indicators in the literature, I identify a small, low-correlated set of potential market drivers and assess which are influencing price action during the most recent, stable market period. Basic to this approach is the notion of regimes: What drives price during one period is not what moves markets at other times. When I place a trade, I'm not simply betting that the market will rise or fall: I am also making the key assumption that the stable (stationary) regime that has defined the most recent past will persist into the immediate future.
For example, in the regime for equity indexes that has been dominant during my writing of this chapter, sentiment and positioning have been statistically significant drivers of prospective price action. When equity put/call option ratios have been high and we've seen rises in cross-sector volatility and correlations, we've tended to see bounces in the S&P 500 Index futures. Conversely, low put/call ratios and modest volatility and correlations have led to inferior returns in the index. During other market periods, sentiment and positioning have not been so important to market returns. Factors such as momentum and market breadth have been far more valuable as market predictors. As Ilmanen notes, the drivers of price action change over time. A successful investor finds tools that capture a range of drivers and thereby harvests profits across market regimes.
There are many ways of understanding and assessing market regimes. John Ehlers, who is well known for his MESA work on market cycles, defines the time series of any asset as the result of a linear (trend) component and a cyclical (mean-reverting) component. To the extent that a market is dominated by its linear component, we want to behave as trend-followers. To the extent that a market is dominated by its cyclical component, we want to fade both strength and weakness. Success is not to be found in being either a momentum or a mean-reversion trader; perennial bulls and bears eventually meet with grief. Rather, the key to trading success lies in flexibility – the ability to adapt one's trading to shifting market environments – just as Emil adapted to the altered dining environment.
An important implication of this line of thought is that, once we define ourselves as one kind of trader, we sow the seeds of our undoing. If we identify ourselves as trend followers, we leave ourselves vulnerable to frustration in low-volatility, rangy markets. If we identify ourselves as faders of market extremes, we open ourselves to getting run over by strong momentum moves. When a market approaches the top or bottom of a range, the strategy that had made money in the cycling environment can now lead to ruin in a breakout mode.
Key Takeaway
The short life cycles of market regimes ensure that successful traders will be the fastest to adapt to changing market conditions.
This, for me as a psychologist, has been one of the greatest surprises working with professional money managers: The majority of traders fail, not because they lack needed psychological resources but because they cannot adapt to what Victor Niederhoffer refers to as “ever-changing cycles.” Their frustration is a result of their rigid trading, not the primary cause. No psychological exercises, in and of themselves, will turn business around for the big-box retailer that fails to adapt to online shopping or the gaming company that ignores virtual reality. The discipline of sticking to one's knitting is destined for failure if it is not accompanied by equally rigorous processes that ensure adaptive change.
But how can we be passionately committed to what we're doing in the present and equally committed to leaving it behind as the winds of change begin to swirl?
When Chris and Gina came to my office to work on their marriage, they showed few signs of being a dysfunctional couple. They spoke in calm, even tones and did not engage in any of the bickering or defensiveness commonly seen among troubled couples. Nevertheless, they were seriously contemplating a breakup. The theme they came back to time and again was that they had grown apart. It wasn't the presence of any great conflict that led them to think about separating; rather, it was the absence of the bond they had once experienced deeply. As much as anything, they wanted to know: Where had it gone?
“Love doesn't die,” the saying goes, “it has to be killed.” In the case of Chris and Gina, however, it was difficult to find a murder weapon or even any murderous intent. Both were devoted to their children and household; both held jobs they liked. “We're a great team,” Chris explained, “we have good times on vacations and no one could be better with the kids than Gina. But it just seems
