Lesson 4: The Interaction Between Process and Psychology

Lesson 4: Process and Psychology interact

In the ongoing series “Seven Lessons I’ve Learned”, we come to Lesson 4. We recognize that we are trying to make the best decisions possible and that we some kind of process and discipline to guide our efforts. On the other hand, we need to get the mental game right to achieve true peak performance, just like with any activity demanding peak performance. What we will address in this piece is how the process part and the psychological components interact.

Of course, we already know that they do overlap. We all have had some experiences with panicking because our position size is too large. We have probably all experienced the frustration of trying to trade well when we are undergoing stress in the rest of our lives or when our performance is lagging. There is definitely a link. The key questions are: What steps can we take so that both our psychology and our process are setting us up for the best results possible? And how exactly do the two sides overlap?

We have covered the need for having a methodology to guide your decisions. The point of this to combat our cognitive weaknesses that can lead us astray. Some are well-known, like emotions and various rationalizations. Others are not as well-known, like information overload. Nonetheless, we should strive to make disciplined decisions where we are making the most rational, collected decision possible.

This is our goal and it’s definitely something to strive for. Ideally, we would become like robots, driven by our programming and able to execute flawlessly. But it will never be quite like that. We are not robots, so there will always be some emotional reactions to contend with. And even if we are doing everything right from a methodological standpoint, we can still be subject to a wave of emotion. Anyone who has a bad losing streak and the accompanying despair can relate. Similarly, a winning streak can leave us almost euphoric, thinking we can do no wrong…until the next sharp drawdown. Or we can chafe at the boredom needed to follow a rigid, disciplined methodology.

The consequences are even greater when we don’t do stick to our methodology. The first is that the quality of our decisions will decrease over time. While it may not show up immediately in our results, it will show up eventually. A run of bad results will depress anyone, especially if those bad results are going to be sustained and unlikely to turn around in a big way. This will be amplified because if we are paying less attention to our methodology then we are probably more focused on the outcome, leaving our emotional state more driven by our results.

The second consequences is that our emotional state will get disrupted just because of how we are doing things. If we aren’t consistent in how we get into and out of positons, then we will become frustrated with everything about our trading and investing. If we are taking too much risk, then we will definitely be prone to panicking out of positions. Dr. Steenbarger, who has been a consultant to many prominent funds and trading shops, summarizes this nicely when he writes in his book Enhancing Trader Performance that “A surprising proportion of emotional problems can be traced to improper risk management.” Basic methodological mistakes can be crippling on many levels.

Of course, I am assuming that someone’s methodology is conforming to the basics of any successful methodology, which I called the Basic Truths of Trading. These are some essential principles which I believe are shared by all successful investors and traders. One is that your methodology has to suit you and take advantage of your personality and your intellectual strengths. Another is that you have a disciplined risk management system which will get you out of losing positions and limit the risk you are taking. Without obeying these Basic Truths, it’s like trying to fight against the law of gravity—you can do it, but you will never succeed and you will always be frustrated. Thus, not only do you have to have a methodology and adhere to it, you need to have the right methodology, built on a solid base.

You have to have the process side sorted in order to have a fighting chance. You need to have in place a defined methodology and you need to be able to stick to it. Some things, like the checklists that I discussed extensively in Lesson 3, are crutches that help you to stick to your system and to maximize its effectiveness. This is the skill that you’re cultivating and trying to carry out, even under the most stressful of conditions. It’s similar to a quarterback who practices his passing so that come game time, he’s able to get the ball to his wide receiver when he has three enormous opposing linemen trying to bury him. Getting the right system and executing it flawlessly means that you will probably have decent results, so you are more likely to feel better. This creates a virtuous cycle whereby you see that see that discipline works, so you stick to it and your results improve, so you keep doing it. In addition, you are less likely to have any of the psychological disasters that come with not sticking to your system, like taking large positions and blowing up.

However, this goes the opposite way as well. Oftentimes, there are some purely psychological factors that interfere with our making good decisions. We can cite several of them:

  • You have stress outside of the markets and you feel like you can’t get anything right in the markets. As soon as the stress clears up, you feel like the markets have become so simple again.
  • “The Freeze”. You know exactly what you need to do, or have to do, and yet you freeze up and do nothing when the precise moment comes. There’s a wonderful SMB blog post entitled “Trading Is All Psychology” describing exactly this phenomenon, when a young trader knows what to do and can’t pull the trigger. He ends up watching the trade run away from him.
  • Fear of Success. While it sounds surprising, some people are scared of success deep down. They may be nervous about how to handle the money or attention, or they believe that successful people are all evil. Whatever it may be, the phenomenon certainly exists. If we don’t know much about the fear, we certainly have seen the result of the fear: choking under pressure. But there are ways to avoid choking and to perform better under pressure.
  • Fear of Failure. In the markets, people can be scared of failure because they are afraid to lose any money. This often shows up as people not taking positions when they know they should, or taking tiny positions where they will never be able to generate meaningful returns.

Ed Seykota summed this concept up best in Market Wizards, where he declared that “Win or lose, everyone gets what they want out of the market”. He is implying that people will get a result that reflects their subconscious motivations, rather than their stated motivations. Ultimately, if we really want to win, then we need to get the mental game sorted—both to be able to perform under stressful conditions but also to make sure that we don’t sabotage ourselves somehow.

At a most basic level, you can dial down the emotions in your trading by shifting your focus away from making money and towards making good decisions. I have written about this before, both in Lesson 1 and in another post, but it’s worth repeating. If you focus on making the right decision, then you are going to pay more attention to the process and getting that right. Eventually, the outcome—P&L—will take care of itself. In this sense, you are to stay disciplined and make sound decisions, and know that you will “take what the market gives you”. It’s a much more liberating way to go, ultimately—you put your emphasis on doing well what you can, and then let the market worry about what the exact outcome will be.

In addition, by emphasizing decision-making instead of money, you are tricking your own mind. By changing what you look at, you are going to be judging your performance on different criteria—how well you’re making decisions. You are shifting away from a money mentality. By not dwelling on money, you will become detached from it in your trading. As a result, you will not be as impacted emotionally. If previously you would think, “I could close this position here and lock in a $5,000 profit. Woohoo! That’s a trip to Vegas”. Now, you’ll think “Is closing this position here the right decision?” This allows you to make a better risk/reward decision, and not to be influenced by the very powerful emotions that are tied up with money.

This is the same method of preparation that top athletes take. They don’t think about the prize and the victory ceremony all the time. Rather, they concentrate on what they have to do at any given moment to get better. That could mean executing flawlessly their technique; testing out numerous modifications to their game; or just getting into the right mental and physical state before game time. But by focusing on the little details of practice or the game, they keep their focus on doing what they can do to get better and to deliver peak performance. If they were to think about the prize or the victory, then they couldn’t deliver their best, as they’re not devoting 100% of their energies to being the best. Furthermore, the emotions associated with the prize would probably interfere with their being able to focus on the nitty gritty of the game.

One related step is to make decisions when you are in the most resourceful state—that means calm, reflected and removed from the hustle and bustle. This is why athletes come up with a game plan before hand and then concentrate their efforts on executing that plan. They can come up with the right plan after much study and reflection; by game time, it’s too late to invent one or to change it significantly. Similarly, you should undertake a whole load of preparation so that you’ll have a few scenarios planned out. “if the stock hits this level, I’ll take profits”. “If the price falls to here, I will stop out”. “If the balance sheet deteriorates further, then I will cut half my position”. With these scenarios in mind, you are being proactive and making your decision when your decision-making powers are strongest. Then you just have to carry out your plan. Otherwise, you will end up reacting in the moment and your plan and its execution will likely disappoint.

In my book, I talk about the two schools of practice that we can try on to make our mental game better: the sports psychology and the therapy worlds. The first is about performing your best under pressure and augmenting what works well so far, using tools such as mental practice. The second is about using tools to effect powerful personality changes, overcoming our weaknesses. Both of these tools work very well to boost our overall performance, and they can easily be adapted for the needs of traders and investors.

One of the most effective tools from the peak performance world is mental practice.  I touched on this in Lesson 2, as it’s one of the key tools of top performers in a variety of fields and has been scientifically demonstrated to aid performance. I have compiled a series on visualization and mental practice. Just as before, we want to simulate trading well, meaning making good risk/reward decisions. Furthermore, we want to practice doing it in a calm, relaxed, emotionless manner.  I wrote a post on How to Remove Your Emotions From Trading, which details a mental practice exercise on how to dial down the emotions that can come up with trading.  Even the most experienced investors will have emotional swings because of the markets and their returns. If you are able to manage these emotions, then it will help you to stay centered and making the best decisions possible.

Another is mindfulness, which means cultivating one’s attention so as to stay on an even keel. Some of the benefits include being calmer, more detached and less emotional. The practice of mindfulness is similar to meditation, whereby you train your brain’s focus. You could try focusing on one single thought, or just on observation. For instance, you could be out for a walk on an autumn day, and you are just trying to look at colors of the leaves, the temperature, the wind, etc. Similarly, you could just pay attention to some aspects of the markets: price action, a company’s financials, etc., and try to keep your focus there. This way, you are truly paying attention to whatever is in your frame.

At the same time, you just let any distracting thoughts drift out of your consciousness, without dwelling on them. Of course, there will always be distractions—our brains always generate random thoughts and feelings. The trick is to learn how to let go of them as soon as possible, so as to strengthen your focus and concentration on the object of your attention or on your sensor experience. The flip side of this is that you gain detachment and practice at letting random thoughts, emotions, and feelings drift in and out of your consciousness without dwelling on them. This detached state keeps you on an even keel emotionally, so that you aren’t whipped around by your emotions or random distractions. It also enables you to stay focused on what matters: the markets. For more on how to cultivate mindfulness, I would encourage you to check out Dr. Steenbarger’s article on mindfulness or Steve Ward’s new book, TraderMind.

Both of these tools will help you to improve your emotional state on the fly and to prepare in advance for any stress. But another key tool will be to get a grip on some circumstances that can add undue emotional stress to your trading. A prime example would be stress. Excess stress will distract you, unnerve you and hurt your performance. It will make it more difficult for you to rest, to stick to your rules and to stay relaxed when you have positions on. Try to remove excess stress from your life. Budget plenty of time for rest, relaxation and time away from the markets, as it really does recharge your batteries. And if you have stressors that you can’t avoid—the death of a loved one, the birth of a child—then you need to accept that your trading will be impacted by these events and reduce your risk. That way, you are reducing the stress or pressure from the markets to an acceptable level. Reduce risk and keep focused on making good decisions, and your account will make it through the stressful times.

Another awful situation to avoid is when you need to make money from your trading, especially if you are hoping for very optimistic performance projections. There is a difference between wanting to make money from trading and needing to. Most people, whatever, their objective, want to make money from their investments: either to fund a retirement, to diversify their wealth, etc. But these people generally aren’t in a desperate position where they need to make money from their investments in order to meet imminent financial obligations. An example of that would be someone who rents their accommodation and needs to make money every month to pay their rent. People who need to make money now are going to become unhinged by the various pressures and probably take too much risk.

This situation will lead you to all of the negative circumstances that I described earlier: focusing on money, not taking what the market gives you, etc. If you are feeling pressure to make money, then that will spike your stress levels and harm your ability to make good, sound decisions. You will feel like someone is after you, always nervous about where to get the money you need, rather than feeling calm and relaxed. Under such a stressful scenario, your decision making and results will inevitably suffer. Either cut down on your expenses, so that you don’t feel the same pressure to make money, or find another source of income to meet your financial needs. And for everyone: only risk capital that you can afford to lose and that you don’t need right now.

There’s a lot of trite wisdom about trading and psychology. “Trade like a robot”. “Be more disciplined”. “Breathe deeply and your problems will disappear!” Unfortunately, this advice ignores the fact that we are human and possess complex, multi-faceted brains. Our minds are a soup of instinct, feelings, thought and emotions. There will be always be a back and forth between the more rational and the more emotional parts of our brain. They co-exist and there will be necessarily be an interaction between them. I’ve tried to highlight some of those interactions and how we can manage them, so as to get the best possible results. Ultimately, if you commit to achieving excellence, you will develop the right skills—such as a methodology and sticking to it—and also the right psychological tools. Together, these will help you make the right trading decisions, helping you to bolster your psychological state; and to manage your psychology so as to help you trade better.

 

No relevant positions

 

By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading

 

 

 

 

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