How we think – Page 2 – Applied Macro

Desire – Why use a stop-loss?

Once you realise how central desire is to processing information and making decisions, you can appreciate how important it is to be able to deal with it. Just being aware of your desires as we discussed in the previous article sometimes is not enough. The process of investment has a direct impact on your emotions and desires – “Fear and Greed” are well known but that does not make them easy to deal with.

If you are not careful, this will be your process

Belief leads to investment
The investment leads to the desire it will succeed
Desire leads to reinforced belief in the trade
The belief leads to confirmation bias
The confirmation bias leads to even stronger belief.

By this stage, your emotional ties have now blended with your beliefs

The risk is that you cannot process new information correctly
You do not get out of the trade when you should and lose money

Introducing the stop-loss

The cycle above is often why books on trading make stop-losses a central element. In fact they are ubiquitous in trading culture, as a hedge fund manager investors would often ask where my stop-loss is on a given position. The theory is clear:

“If you have a rigid and clear stop-loss, which you decide before you enter a trade, and then remain disciplined in sticking to it, then you are protecting yourself from your own inability to objectively evaluate the position after you have put it on.”

This is great advice for most investors. Another great piece of advice would be:

“DON’T TRADE – you aren’t any good at it and will lose money”

The books tend not to mention that one.

IS there an alternative?

A problem with a stop-loss is the trade might still be a great trade. In fact, it could be better or worse that when you initially traded. New information will have become available, but by pre-committing to get out of the trade, you are not able to do anything about it.

There are other ways to manage positions aside from stop-losses. I borrowed a helpful way to think about this problem from George Soros – please read “The Alchemy of Finance” – a truly wonderful book with some very important ideas. One of Soros’ key ideas is the application of Popper’s scientific method to investing. The application of hypothesis testing.

Key is not to start with a “belief” that the trade will work, in fact the trade is a test of the hypothesis that the trade will do well.
Analysis is therefore considering what would falsify this hypothesis.
Hypotheses are falsified all the time and it is nothing to get very excited about.

Therefore, desire is not engaged or at least minimised.

This willing suspension of belief is critical to being able to remain objective later.

What can falsify a hypothesis. For example

Fundamental news invalidating the underlying idea
Price action that tells me what I thought matters in this market, is not what really matters
Price action that tells me there is something going on I do not understand.

In practice, this can look very similar to a stop-loss, but It leaves the door open to more discretion and flexibility. For example:

Fundamentals have worsened while the price action is fine
EXIT i.e. do not wait for the stop-loss
Fundamentals have improved while price action is poor
Do not automatically exit as some of the most profitable opportunities from these times of material mispricing. Do more investigation.
Possibly INCREASE the position size rather than cut it

Conclusion

Working with Soros, I observed that this process allows him to be enormously flexible. He does not seem to fall into the standard pitfall of emotional attachment to his trades. Instead fluidly cutting, increasing or reversing them when he changes his mind. This level of control and discipline sets him apart from the vast majority of traders I have seen.

Desire – The Fatal Flaw

“That’s the trouble with hope. It’s hard to resist.” The Doctor to Missy

Desire is everywhere

I introduced the link between desire and beliefs in my last post. As humans, this is how our brains are wired. A way to think about the human thought process is this:

Desire is dangerous and hard to resist

Recently, we have witnessed desires replacing beliefs as the central element of the political discourse. The recent Brexit campaign was perhaps the ultimate triumph, as the debate centred on deep seated desires “Do you want to leave the EU?”

The Leave campaign focused on stirring powerful emotions, whereas the Remain campaign had no emotional resonance, relying upon things no-one cares about such as economics and facts! The level of debate was astonishingly poor because it was not really a debate at all. It was an emotional primal scream and clear evidence that desire leaves beliefs trailing in the dust.

How to combat desire

One of the ways that I combat the power of desire is to try to become consciously aware of it. If I have a belief, I try to work out if it matches with my desires. If so, I may be prone to desirability bias and note it as something to be wary, of as we mentioned in the previous piece. This is especially important for doing fundamental analysis for trading, where is can easily influence my decision-making process.

Let’s use some recent examples:

I remind myself to tone down the potential importance of anti-Trump developments

I read Fox News and the NY Times,
I watch John Oliver and …. OK I cannot watch Fox and Friends

I read the Telegraph every day during the Brexit campaign

If my belief does not match any desire I have then I note that while I might still be wrong it is unlikely this type of error. For example

I do not want the UK economy to be wrecked, but I think that Brexit might do it.
I have no particular love for the EU, but I think Brexit is a disaster.

This means that my belief that Brexit is a disaster likely comes from my analysis rather than by analysis being driven by my desires. I still have to consider other ways in which I might be wrong but eliminating the really disastrous one is the most important.

I would prefer that the US equity market were very cheap

So my analysis that it is expensive is disappointing but likely not driven by a desire.

Desire is a particular problem for investors

Investors are particularly vulnerable to these problems of desires influencing beliefs.
Given that our beliefs on the market require frequent updating based upon new information, any cognitive error in processing such information can often lead to poor decisions and emotion taking over. The related but more important problem is our desires as investors are not independent from the act of investing. The very act of making an investment changes our desires.

Let’s use an example is have used many times in the past 25 years.

Imagine I take you to a racetrack.
There is a race coming up and I ask you which horse you think will win.
You do not know much about the horses and so have no view independent of the odds you can see posted.
I give you £10k and say you have to put it on a horse that is 5-1. If you win you get to keep the winnings.

Now you care.
You are going to have £50k in your pocket if your horse comes in and nothing if it loses.

What do you think happens during the race? I bet you get pretty excited. When your horse is edging in front with 2 furlongs to go you are jumping up and down with excitement and are convinced you are going to be rich.

I offer to pay you £10k now to cancel the bet. You look at me as though I am crazy or trying to steal from you as you are about to win £50k. you are very confident.

Your horse tires and comes in sixth. Your horse is a well-known front-runner who tires badly. But you did not seek out that information and are shocked and deflated.

But it was pretty exciting and you can’t wait to do it again.

Conclusion

If you do not combat it what you want to believe will have a dominant impact on what you end up believing to be true. If you sit inside your bubble only listening to people you like and respect then you may be falling prey to Desire.

Decision making – systematic flaws & biases

Everyone knows that we are not hyper-rational calculating machines. We are prone to bias in how we seek out and process information. These biases are often invisible to us, but make a big impact on our behaviour and decisions. It is not only interesting but also important to understand your own tendencies, and as a trader and investor critical to improving your performance.

It also applies in the sphere of economics, where behavioural studies show that people do not behave in the way that the neoclassical “rational” person is supposed to.

Confirmation Bias

The cognitive bias that gets most attention is confirmation bias i.e. a tendency to search for and favour information in a way that supports your beliefs. This is critically important for anyone who makes important decisions. It manifests itself in a variety of ways:

Seek out information to support and reinforce our beliefs
Ignore information that undermines our beliefs
Surround ourselves with people who agree with us
Like and reward people for agreeing with us
Dislike and punish people who disagree with us

I remember seeing lots of these behaviours when I worked in a large organisation. Of course, you will probably see it most clearly in the people you dislike, but perhaps be rather blind to it in yourself or your friends.

In modern politics, politicians seem to be particularly prone to it:

Trump – an extreme case, a caricature of confirmation bias
Theresa May – surrounded by a small loyal group and not listening to outside advice
Jeremy Corbyn – adored within his bubble

It’s easy to see that confirmation bias leads to:

Over-confidence
Polarization
Wishful thinking

These characteristics may not be harmful to you in your life or career. That is why they can persist. For example, for many senior politicians, it has clearly not harmed their careers. Over-confidence is simply seen as confidence and that is appealing to people who want to believe in a leader. However, characteristics such as these are fatal to someone who wants to make successful investment decisions. Before I move on this in the next post, I want to introduce another source of bias that is deeper routed, more important, harder to detect and most people may even not think of as a bias!
Beliefs and confirmation bias are only one part of decision making.

Desire

We all have desires, they are a powerful and primal part of our being. You probably think of them as part of your emotional brain but have you considered that they have a relationship with your beliefs – a bias to believe what you want to believe.

It is so prevalent the examples are legion. Here are some examples:

Capture

Of course, you can have beliefs that do not align with desires, the relationship is not deterministic. You can support Man City but think Chelsea will win, or you can support Chelsea and think Man City will win. However for the most part, it seems more natural and harmonious when our beliefs and desires do line up. If you doubt the power of desire, please spend some time to make a list of your current beliefs which are strongly at odds with your desires. I think the list is not so easy to come up with.

It is then important to consider what drives what in this relationship. There was a recent study in which psychologists (Tappin, McKay and Leer) designed an experiment to separate beliefs from desires. They gave opinion poll data to US voters and what they found was that desires dominated. For example, optimistic Clinton supporters and pessimistic Trump supporters both believed that Clinton would win. When given new polling information suggesting that Trump would win the Clinton supporters ignored it and the Trump supporters incorporated it to become more optimistic. https://www.nytimes.com/2017/05/27/opinion/sunday/youre-not-going-to-change-your-mind.html. They called this “desirability bias”.

It is how our desires and beliefs interact that make this effect so important:

If our desires and beliefs are aligned
Confirmation bias will be even stronger.
If our desires and beliefs are not aligned
Then we change our beliefs!

Often confirmation bias is easy to spot, but the desires that predispose you to seeking confirmation bias are hidden and much more important.

This result is not surprising to anyone who has worked on a trading floor or played high stakes poker. The strong emotions and desires that come from the large sums of money involve permeate the environment and can easily overwhelm most people. For a trader or investor to be successful you need to be able to make good decisions. If you have a significant bias in your decisions making then you will fail, sometimes catastrophically.

Conclusion

Your desires will have a huge impact on your beliefs, how you process new information and the decisions you make. The problem is most people believe that their beliefs are rational and do not understand their often-emotional core. Developing ways to deal with this can have a dramatic impact on your performance. In the next post, I will talk about some ways I have dealt with this in my career.

Feedback

As a member of many teams over the years, both leading and contributing, I have learned a lot about feedback. How it is dealt with is a core aspect, not only of work culture, but also in all our relationships. In this post, I will deal with the kind of feedback which is meant to have a purpose, that of improving performance, often thought of as coaching.

Coaching is at its most useful when it is an active exchange of mutual learning. On the one hand, I find I learn so much trying to explain concepts to others, whilst on the other hand I very much enjoy the experience of being coached myself. Effective coaching is rarely dominated by telling people what to do.

Encouraging self-reflection and evaluation within a context of mutual respect and desire for improvement are critical to achieve progress. You cannot presume that someone wants a coaching relationship with you, and they may perceive attempts to coach them as unwarranted criticism.

I think it is helpful to break feedback down into 3 types: praise, encouragement of self-reflection and evaluation, which can be either objective or subjective. It is also important to make a distinction based upon the type of relationships or power dynamics involved.

This leads to a grid, similar to the one used in “How to Write”.

Type 1 – Praise

Very often when people say they want feedback, they only want praise and it quickly becomes a vacuous form of feedback. We have all heard the disparaging stories of “millennials” who are conditioned to expect it. Indeed, I have come across this problem with juniors but I feel anyone adjusting to the world of work, especially straight from university, may find the real-world environment a challenge. I probably did myself.

People who have had a career in a more protected environment, or who have low self-esteem, may also need frequent reassurance that their work is valuable. We see that praise is the only form of feedback that Donald Trump can tolerate. Whereas seasoned and successful professionals tend not to seek praise as much. They know that when validation of their work comes, it is well deserved but their self-esteem is strong enough not to require it.

Like most people I enjoy being praised, but If I am highly praised for something I do not consider particularly worthy, then it has very little meaning to me. My greater desire is to learn and improve, so I actively seek other types of feedback. However, I do believe that praise is underrated as a feedback tool and it can be a very effective form of teaching, positively reinforcing good behaviours if used selectively. This is the way that I like to use it and to receive it.

As parents, praise is totally natural, we proudly clap our children at the slightest provocation. Children are naturally experimenting with behaviours and desperate to learn through new experiences, so selective reinforcement is very powerful. Genuine strong praise for a child who has tried hard at something is mutually rewarding and comes very naturally.

Overall, my approach is to try to use praise genuinely, but it is not as easy as it sounds. At work, I often start with praise but mix in other forms of feedback. This often carries the risk that the recipient may not hear the praise at all, and in fact perceive the whole conversation as pure negative criticism, especially given our power relationship. Furthermore, where the need for praise is too strong, then validation becomes an obstacle to learning in itself. If they receive a lot of praise, then why change behaviour?

A general principle is that people tend to give out the type of feedback they like to receive themselves. If I am managing a person who only wants praise, I struggle to manage them and these relationships have not worked for either of us

Type 2 Encourage self-evaluation

This is simply asking someone their thoughts on what they did or how they feel something went.
This is a type of feedback that may not register as feedback to many people, it does not involve any praise or criticism, no evaluation or active coaching.
The idea is to encourage reflection and to start a conversation from which you both can learn.

This style of feedback comes naturally to me and is most enjoyable if the other person wants to participate. Receiving this type of feedback from investors, it led to the most enjoyable and engaging conversations and I think I learned the most.

Remember the most common source of this form of feedback is yourself!

Type 3a Evaluation – Objective

This is a very important type of feedback if you can get it.

In modern sport, virtually every facet of the game is reduced to statistics which can be measured and help form the development of training drills to enable a player to improve. Purposeful practice requires a solid feedback mechanism.

Learning without a reliable feedback mechanism makes objective evaluation much harder. Learning to trade for example. A market making environment lends itself to objective evaluation as the number of transactions is likely to be high and the speed and accuracy of pricing can be easily observed. But it is one of the reasons that learning to trade by taking risk in markets is difficult, as in the short term the element of luck is large enough to create noise in the consequences of your decisions.

If evaluation is clearly objective and applied transparently to all staff, then it is likely to be accepted. But the attractions of this type of feedback are also its drawback. It is appealing to generate objectives which are measurable, but not necessarily relevant to the goals of the organisation. Think of the Blairite obsession with targets in health and education, which created distortions in incentives.

Type 3b Evaluation – Subjective

Subjective evaluation is the most overused form of feedback, and most people seem to think this is what feedback is. If you look at the forms that HR demand you fill out for conversations with your staff, you will see the word evaluation everywhere. This is often combined with a requirement to assign scores or rankings to various aspects of the employee, creating the illusion of objectivity but they are actually the opinions of the manager.

Subjective evaluation may have a place. If your intent is to make a complaint then this can take the form of a negative evaluation, for example if you want to complain to a hotel you can give a low rating on TripAdvisor. But there is wide variation in the quality of such comments. In large firms however, negative evaluations are used almost exclusively as part of the process of firing employees.

When I ran a large fund, I had hundreds of investors, old and new, continually evaluating me. If I agreed with the evaluation, it was likely it became an experience of being berated rather than a learning point. If I did not agree with the criticism, I still had to take it.

In close work environments, the giving and receiving of such feedback can be a minefield. It can be hard to receive emotionally, especially when the receiver doesn’t accept the view or worse the right or competence of the person to evaluate them. Unsolicited feedback is pure criticism – no one likes to be criticised. This is why, in practice, most work evaluations turn into exercises of giving praise, even when it is not genuinely deserved.

The relationship matters

What is striking about the workplace is how little useful feedback is given and/or taken.

If you are the in a position of authority, care must be taken not to blindly hand out feedback that could be construed as pure criticism. Remember anything you say has a magnified impact, given the nature of your relationship. Consider layering in the various forms of feedback I mention, remember the idea is to help your employee, not to add unnecessary strain or distance.

If an employee receives feedback that they don’t like, it can often be seen as confrontational or rude, and instead of trying to work out what was the purpose of such feedback the employee is more likely to grumble about them behind their back. A very poor outcome for both parties.

If you are a person who wants to improve, you need to actively seek out feedback from people you respect, this is key to improving performance. Avoiding criticism is an ingrained social habit, so bear in mind you need to be prepared for an honest evaluation. Keeping any defensive reaction in check is important as if you react defensively, you are likely not to hear honest feedback again. You should thank the person for the feedback and do your best to understand it. If you think it is completely wrong, then you still have an important learning point, that someone you respect perceives it to be true.

Conclusion

How to manage feedback is one of the most important aspects of work culture and defines whether your organisation is going to merely stagnate or rather learn and develop.

As a giver of feedback, it is important to recognise what kind of feedback the person wants and will be able to process.

As the receiver of feedback, you have the main power. You can be defensive and only accept praise, or you can actively solicit opinions which you can incorporate into your learning process.