Over a decade of working with professional traders and portfolio managers in financial markets has provided me with a unique front row seat on behavioral finance. There are few cognitive biases that I haven’t directly observed in my own trading and that of the money managers I work with. Interestingly, however, I would not identify a lack of discipline or biased thought as the greatest psychological problem affecting investors. Rather, traders suffer from what I would call a cognitive/emotional mismatch. Such a mismatch occurs when there is a disconnect between the thought processes of traders and their emotional response patterns. This causes them to manage market positions in ways that do not match their initial intent, undercutting their effectiveness. In this two-part series I will first outline the dimensions of the problem and then point the way toward solution.
The Psychology Of Commitment
The concept of commitment implies a continuity of purpose and behavior. When we are committed to a marriage or a career, those become central to our identities. Our day-to-day lives, as well as our longer-term plans, are organized around those commitments. To no small degree, commitments are the glue of our lives, providing much of life’s meaning and value. Whether we are committed to our religious faith or to an entrepreneurial startup, commitments express our intentionality. A life without commitment is a life lived relatively randomly.
A neat formulation of positive psychology comes from Martin Seligman, who coined the acronym PERMA to capture five elements of optimal human experience:
- Positive emotions
- Engagement
- Relationships
- Meaning
- Achievement
If we think about our life commitments, they are important precisely because of their potential to fire on all five of these cylinders. They are sources of positive emotional experience; they absorb us and provide a sense of engagement; they contribute to our sense of closeness with others; they are deeply meaningful and rewarding; and they provide a sense of personal accomplishment. In sum, commitments help make us happy and fulfilled.
Here’s the rub, however: what makes us happy is not always what makes us fulfilled and vice versa. As researchers have noted, positive mood and happiness are surprisingly independent of life satisfaction. The commitments that, over time, can yield considerable life satisfaction often require short-term sacrifices of what would make us happy at the moment. When our longer-term aspirations conflict with what would gratify us in the near-term, we have the makings of a cognitive/emotional mismatch.
A simple example is all too familiar to most of us: getting in shape would give us more energy and make us feel good about ourselves. We therefore vow on New Year’s Day to commit to a program of exercise and healthy diet. Later, however, we find ourselves discouraged by any of a number of challenges at work or home. In our depleted state, exercise feels like a chore, while eating desserts promises to make us feel better. Imagine this dynamic playing out week after week, month after month and it’s easy to see why relapse is such a challenging problem for psychologists. Initiating change is far easier than sustaining it, precisely because we’re wired to pursue our moods as well as our longer-term interests.
An extreme version of cognitive/emotional mismatch can be found in the recent reports of employee stress at Amazon. When employees are pushed far beyond their comfort levels to become ever-more productive—whether on assembly lines or in the corporate suite—the result is a profound conflict between what would make them happy and what would make them successful. This is precisely the conflict faced by couples that lose the joy in their relationships: commitment becomes harder to sustain when it chronically runs counter to happiness.
Recall that engagement is one of the five PERMA constituents of positivity. When employees do not feel engaged in their work, their productivity suffers. That point is nicely illustrated by Adam Grant , whose work links success less to extreme effort than to a meaningful giving of oneself. When we give a gift to someone we care about, there is no cognitive/emotional mismatch: what makes us feel good is also what we find deeply satisfying. If we are required to give of ourselves day after day with little recognition or sense of purpose, as in the telemarketing call center described by Grant, there is fertile ground for mismatch. Under those conditions, we’ll find any emotional distractions—from hanging out at the water cooler to surfing the web—preferable to our work commitments.
How Cognitive/Emotional Mismatch Undermines Investors
Any trade or investment is a commitment of capital. For a money manager, an investment is also an investment of time, effort, and aspirations. The effort required to research markets, macroeconomic conditions, and geopolitics is gratifying if it can yield decisions that profit all concerned. There is joy to be found in the generation of promising ideas and the effective trading of those; there is also satisfaction to be found in mutual success. Under ideal conditions, where there is a love of both process and outcome, there is no cognitive/emotional mismatch: traders are truly invested in their craft.
The challenge occurs when we desire positive returns but cannot tolerate losses. This can occur because of self-imposed performance pressures or a risk-averse personality style. It can also occur if those allocating capital are unwilling or unable to sustain even a normal degree of loss. We know that any trader with a solid, realistic Sharpe ratio who targets a very low double digit return will encounter drawdowns of over five percent solely as a function of chance. At many firms, however, such losses would be sufficient to trigger a flight of capital by investors and a loss of one’s job as a trader. For the independent trader who might be targeting returns of 20% or more, the likelihood of double digit drawdowns rises substantially—an outcome that is intolerable for many managing funds intended for retirement.
When the demand to make money is yoked to the imperative to not lose money, the mandate becomes one of gun to head: succeed or else. That is surprisingly similar to the call center productivity mandates described by Grant. It sets up a cognitive/emotional mismatch in which the commitment to effectively manage capital collides with the emotional need to avoid the third rail of taking losses.
Consider an analogy: If a baseball coach were to tell a player that he would be fired if he struck out, the batter would feel considerable stress. He would likely focus on making any kind of contact with the pitch so as to not strike out. In other words, he would swing to not miss, rather than swing to hit. He would probably put the ball in play—and he would most likely produce one miserable ground ball or pop fly after another. It is difficult to take a healthy swing at a pitch if you’re not allowed to miss.
So it is for many traders and investors. The twin mandate to make money and not lose money creates the mismatch felt by the batter. For traders, this manifests itself in a very particular way: the management of the trade no longer matches the scope of the idea behind the trade. For example, an investment might be triggered by a careful analysis of central bank policy and the anticipated impact of that policy on future interest rates. Such an outcome might be expected to play out over the course of many months and central bank meetings. If, however, the volatility of the rates markets is high over this period, random price movement could easily generate paper losses that would threaten the need for tight risk management. Unable to weather adverse price movement, money managers either grossly undersize investments or turn them into trades, chopping in and out of positions originally intended as medium-to-long term views. Like the baseball hitter, they deploy capital to not lose, rather than to win.
To be sure, there are investors and investment firms that successfully meld risk and performance expectations, just as there are workplaces that create cultures that support employee engagement. Those will be the focus of the second part to this series. All too often, however, the cognitive/emotional mismatch is evident, as money managers plan their trades but then cannot trade their plans. Their commitment to growth of capital clashes with their need to stay comfortable and avoid losses, and their less than optimal compromise is to express longer term themes as short-term trades. It is as if a person fearful of relationship breakups were to settle for an ongoing series of casual dates, never fully achieving the satisfaction of commitment.
From New Year's resolutions to successful investment, how can we better align what makes us feel good in the short run with what will prove satisfying over the long haul? A solution-focused framework provides important clues and that will be the focus of the second post in this series.
