MARK RIEPE: Welcome to season 7 of Financial Decoder, an original podcast from Charles Schwab. I’m your host, Mark Riepe.
This podcast is about financial decisions and the cognitive and emotional biases that can cloud our judgment.
Decision making is incredibly important. In fact, it’s estimated that the average adult makes about 35,000 conscious decisions every single day. Some of these are big and most of them are small, but because there are so many of them, if we can improve that process just a little, it’s a good thing.
We’re never going to be perfect, but there are many techniques that can be used to help us out. What we do on this show is to help root out biases that creep into our decision-making process when it’s applied to financial matters.
The goal is to identify a bias and employ mitigating techniques to combat it, overrule it, and make a better choice.
The techniques we use in trading and investing are kind of like the equipment we use to play sports. For example, when you’re a beginning golfer, you start with a small number of clubs that are relatively easy to use when hitting the ball. After all, you’re learning the fundamentals. As you gain experience and take more lessons, you add a few more clubs.
Once you get to the point where you’re a regular golfer you’ll be playing with 14 clubs. That’s the limit imposed by the PGA Tour on the number of clubs that can be carried and used in a single round.
The reason there are so many clubs is that each club allows you to control different angles and make effective shots from different distances.
One of the differences between a top golfer and a mediocre one is that the top golfer has mastered all these clubs and the conditions under which they are best deployed.
Trading your portfolio has many similarities to this. You start out employing a few simple techniques, but build up the number of tools in your toolbox as you gain experience.
Over time you learn more about the markets, as well as how to recognize the psychological biases that stand in the way of your investing goals.
Only after you’ve had some experience and gained knowledge can you choose from a variety of more advanced strategies to help you get the results you want.
Our focus today is on the cognitive and emotional biases that crop up when trading stocks and the many different techniques that can be used to control these biases.
My guest is Randy Frederick. Randy is vice president of trading and derivatives here at Schwab, and he focuses on client education and market analysis.
Randy’s published in several trade magazines and is a frequent guest on all of the important financial TV networks, and he’s often quoted in publications like The Wall Street Journal, Barron’s, the Financial Times, and MarketWatch.
Thanks for being here, Randy.
RANDY FREDERICK: Thanks for having me back, Mark.
MARK: Randy, as you know, the purpose of the show is to discuss cognitive and emotional decision-making biases and how they connect to financial decisions.
The idea for this episode is, we want to talk about different biases and to see if you can draw a connection between some classic trading techniques and how they can be used to mitigate the effects of those biases. Does that make sense?
RANDY: It sure does. Biases seem to affect every part of our lives and certainly trading is no exception.
MARK: So let’s start off with some emotion-based biases. This past weekend I was reading a study about how our emotional state influences financial decisions. Specifically, how sadness influences the decisions we make. Basically, the bottom line of the study was that people, when they’re feeling sad, they will, on average, be making financial decisions more associated with impatience.
The theory being that none of us like to feel sad, of course, and so we’re tempted to make decisions that have a short-term payoff to kind of get us out of that sad state, if you will, but those decisions don’t make sense, necessarily, over the long term. And then they go out and provide some empirical evidence showing that this is, in fact, the case. So my question to you is whether you think this might apply to traders?
I mean, it seems to me that if your recent trades haven’t been working well, then, you know, maybe you’re losing money, you just might want to start off making the kinds of trades that maybe pay off real quickly, but they do come with a price of perhaps being riskier than normal.
RANDY: You know, I think there are several directions we could probably go with this topic. I always hate to draw parallels between trading and gambling, but I do think that when traders make bad decisions, it’s often because they’ve developed a gambler’s mentality. So I think the comparison makes sense if the purpose is to point out how a trader should not think like a gambler.
A key trading principal taught by many, and I agree with it, is that if you’ve had a string of losses, it might be good to either trade less or trade smaller, until you get a few wins under your belt. Obviously smaller wins won’t impact your bottom line as much, but they can have an extremely powerful emotional impact. In other words, when you’re down on your luck, what you need is a confidence booster; and a few wins might be just the ticket.
However, if your string of losses is being caused by something other than just bad luck—like maybe you’ve changed your strategy, or you’ve started listening to a so-called expert who really isn’t, whatever—trading smaller will help there too, because any additional losses will have a smaller financial impact to the downside too, and that’ll help you buy some time to figure out the problem. Now, this kind of behavioral change, I think, is the right thing to do.
On the other hand if, as you mentioned, you adopt a riskier strategy of trying to gain back your losses quickly, you’re probably just setting yourself up for even more disappointment. You know, this is the old “double-down” strategy. A bad investment on 100 shares doesn’t get better if you double it. It just becomes a bad investment on 200 shares.
MARK: Yeah, it’s sort of like the old rule “if you’re in a hole, the first thing to do is to stop digging,” right?
MARK: So what kinds of rules of thumb or trading rules do you recommend that people can use to protect themselves or get themselves out of this situation?
RANDY: Well, as I just mentioned, while it may seem counterintuitive to traders who have a high tolerance for risk, it almost always makes sense to reduce the size of each trade when the risk is higher; and frankly the risk is higher if your capital base has already been reduced by losses.
Of course, risk and reward go hand in hand, but like leverage, risk is a double-edged sword. As you know, the more risk you take, the greater the chances that you’ll reap big rewards. But, if you’re taking on more risk, there’s also a greater chance that you could incur big losses. It’s pretty difficult to increase your profit potential without also increasing your loss potential.
MARK: Yeah, I think investors and traders alike—a lot of times they’ll forget that the holes they’re inadvertently digging can be deeper than they realize. That’s kind of a conceptual point. Do you have a numerical example that illustrates that?
RANDY: Yeah, let’s take an analytical approach and consider the way percentage gains and losses are calculated. If you buy stock, say XYZ, at $50 per share, a 50% increase in the value will get you up to $75 per share. However, if the stock then decreases in value by 50%, you’re not back to your original $50 per share—instead, you’re only at $37.50 per share, and that’s an overall loss of 25%. And here’s the thing: The effect is even more dramatic when you start with a drop in price. So suppose you buy XYZ at $50 per share and it sustains a 50% drop—that takes you down to $25 per share. In order to get back to your breakeven price, you don’t need a 50% increase in price—you need a 100% increase. Clearly, it’s far more common on any given day for a stock to drop 50% than to gain 100%.
MARK: So and that’s where your point about reducing the size of trades comes in. All those numbers go down, particularly the dollar amounts, if you’re dealing in smaller percentages. What else do you have that can help with when you’re in a bad emotional state?
Randy: Well, one way to deal with all of this is to have some kind of a trading plan. In many ways, a trading plan is kind of like a business plan. It should outline what you’re trying to accomplish and how you are going to accomplish it. Every trading plan is a little bit different, so there’s not really one template that works perfectly for everyone.
MARK: So we talk a lot about, you know, the benefits of planning, but you know, as you just mentioned, not all plans are created equal or make sense for everybody, so maybe let’s make this more concrete. What are some specific examples of things that people should think about including in their trading plan?
RANDY: Well, a trading plan could include a lot of things, so here’s a list of ten items that I think would be useful.
- First of all, the products that you plan to trade.
- The trading strategies that you’re going to use.
- How much money you’re planning to invest in each trade.
- Set some realistic profit goals.
- Also, some loss thresholds, because that’s important.
- How you’ll make those investment decisions.
- How and when you’re going to conduct your research.
- How much time you’re going to devote to that research.
- And then what resources you’re going to use for that research.
- And finally, and I think this is the most important piece, a trading log or a way of tracking your results for both your existing open positions—so you can track unrealized gains and losses—as well as the positions you’ve already closed out.
A trading plan doesn't have to be complicated, but it should allow you to manage and track these key items. Most importantly, your plan should be a work in progress. As you refine your approach, you can add more detail to your plan over time.
MARK: Yeah I think if you hit replay for 15 seconds, think about those ten items, most of those make just a lot of common sense—it’s just a matter of people actually doing it, and I think your point about refinement makes a lot of sense as well, because we change, we learn, our situations are different. So don’t treat a plan as something set in stone. Let’s move on to another emotion here.
Sadness is of course one type of emotion, but stress is another type of emotion or situation. And there’ve been studies where traders have actually been kind of, you know, strapped up in health monitoring devices, and their heart rate and their blood pressure has been checked while they move throughout their trading day. One of the things I took away from reading that work, though, is that experienced traders, you know, they did a better job of controlling their stress, but they certainly didn’t eliminate it.
And so my question to you is, if emotions can sometimes create stress, and it’s not really possible for us to eliminate it, how do you go about managing it then in a productive manner?
RANDY: You know, it’s almost a universally held belief that to succeed as a trader, you have to learn how to control your emotions. There’s only one problem—that doesn’t mean that if you could just control your emotions, you’d have trading success, but it does mean that if you don’t, you most certainly won’t.
But that’s easier said than done. Humans are emotional beings by nature. And as you’ve talked about many times in the past Mark, the pain of a loss hurts much more than the joy of a gain. So I find it hard to imagine that anyone could completely neutralize those feelings altogether. So I think the key is to recognize that you will feel those emotions. And since you can’t fully suppress them, what you really have to do is just not allow those emotions to influence your investing decisions.
MARK: Makes a lot of sense. Do you have a checklist, sort of like you provided with the trading plan? A checklist of things you should be thinking about to make sure this happens?
RANDY: Yeah, I’ve got lots of checklists, but this one specifically for equity traders, I’ve got four specific suggestions that I think can help.
- First one, it’s one we talk about all the time: Diversification is key. If you don’t put too much in any one stock, then no sharp downturn’s going to hurt you too badly.
- Avoid using most or all of your available margin buying power. If there’s a small downturn in the market, you won’t get a margin call, and you won’t be forced to liquidate at the worst possible time.
- And then consider using index and sector ETFs. Not including leveraged and inverse ETFs, because those are only suitable for short-term traders, but ETFs in general offer built-in diversification. So if one stock in the portfolio goes up a point, and one stock in the portfolio goes down a point, the ETF is unchanged. And that tends to make them far less volatile overall than individual stocks.
- Essentially, I would summarize it this way: The best way to avoid an emotional decision is to avoid putting yourself in a position where you might be forced to make one.
MARK: Randy, we’ve got some undoubtedly newer investors listening to this episode, and we try to kind of bring them along a little bit by defining some of these more complex terms. Is it possible to give kind of a quick explanation of what you mean by “margin buying power”?
RANDY: Yeah, so margin buying power or “buying on margin” is essentially where, when you buy stock, you can borrow part of the cost of that stock from your broker, rather than paying for it all up front. So you’re essentially buying it partially on credit. What happens is if the value of that stock goes down, at some point your ownership portion gets so small that your broker issues what’s called a margin call. And then you either have to come up with more money, or you might be forced to sell part of that stock. The problem is, when you sell it, the stock price will be way down, and it’ll be the worst time. So I basically say try not to ever let yourself get in that position.
MARK: Yeah, it makes a lot of sense. Let’s go on to another bias, and I’ll call this one the ostrich effect. It sort of comes from this apocryphal story of ostriches, when feeling threatened from predators, they just stick their head in the sand. In the context of investments, some people have found that investors check their account balances more when they’re going up in value and less when the accounts are dropping in value.
So this is kind of a tough one, I think. How do you force yourself to look at all the news and all the information– even when it’s delivering a message that you may find uncomfortable?
RANDY: Well, you know it’s fun to look at unrealized gains. I think we all do that sometimes. Likewise, ignoring bad news can be a good thing if it keeps you from making an emotional decision. One of the hardest parts of investing is that the right thing to do is often the exact opposite of what your emotions are telling you to do. So when the market’s down sharply, your gut often tells you to sell, and when it’s up sharply, your gut tells you to buy. But sell low/buy high is not how you make money in the market.
We’ve all seen investors panic sell in a down market, only to regret it once the rebound happens. So sometimes it might be best not to look at your account when things are bad.
Earlier this year, for example, when the coronavirus first hit, we experienced the quickest bear market in history. From February 19 through March 23, which was just 33 days, the S&P 500® fell 34%. That bear market was immediately followed by the quickest rebound back to a bull market in history. So by April 9, just two and a half weeks later, the S&P 500 had risen 20%, and within 6 months, the S&P 500 was back to a new high again.
Now, this is certainly an extreme example, but not only was panic selling not a good decision this year, it also wasn’t a good decision back in 2008 or 2009. Now it certainly took longer for the S&P 500 to rebound, but it’s risen 400% since that time. One statistic that I like to share on this subject is that in the post-WWII era, bear markets on average have only lasted about 16 months, whereas bull markets have lasted about 62 months. So often the best trade to make is no trade at all.
MARK: Yeah, I think 2020 has been such an emotionally fraught year that people will be studying kind of the intersections between the economy and the market and investor behavior, I think, for many years. There have been just so many great examples, just like the one you just provided.
Let’s turn now to kind of the cognitive side of things. And one problem we all suffer from to a certain extent is wishful thinking. And I call that a cognitive bias, not an emotional bias, because it really involves thinking about the future and what might happen. By that I mean we’re thinking about a potential trade, maybe it’s a trade we like, when we start looking into it more deeply, we find that it’s easier to imagine circumstances where it will turn out well, and we’re less able to find out or imagine circumstances in which it might not turn out so well.
So what are some techniques to help us kind of take off our rose-colored glasses and look at the future a little bit more clearly?
RANDY: You know there’s certainly nothing wrong with taking an optimistic view, but it has to be based on reality. I always find this type of thing fascinating because it speaks to how little most people understand probabilities. When I discuss probabilities with traders, I often remind them that if the probability of a particular outcome is greater than zero, it can, and sometimes does, happen. A low probability doesn’t mean it won’t happen; it only means that it isn’t likely to happen. But the more times you test it, the more likely it is to occur.
I mean, I’ve heard people say things like, how could something with a probability of only 5% happen? Well, the answer of course is because it had a 5% chance of happening. Just because it happened doesn’t mean the 5% probability was wrong; it would only have been wrong if the probability was 0%. In fact, if you test it 20 times, it isn’t just possible it’s going to happen—it’s likely it’s going to happen.
Think about the probability, for example, of flipping a coin 10 times and having it land on heads 10 times in a row. Some people would say that’s impossible, but they’d be wrong. If you flipped a coin a thousand times, it’s likely that there would be at least one instance during that time in which the coin did land on heads 10 times in a row.
So, finally, if you’re still convinced that a strategy you’re considering has the potential to beat the odds, by far the simplest way to test it out is to paper-trade it; just pretend to buy it, using fake money, and then see how it works out. But be honest. You have to be honest when you do this. Don’t look at it and say, “Oh yeah, I would have bought that back when the price was lower.” Actually write it down on paper and then check it each week. Or you can use some of the tools we have available—this is how I like to do it. I create a watchlist on StreetSmart Edge. And I enter the symbol and use the Notes feature to record the fictitious price that I would buy it at. If you paper-trade the strategy and you can do it successfully twice in a row, then maybe it’s worth considering using real money.
MARK: Let’s move on to another bias, and that’s called the attribution bias. The essence here is that we tend to attribute the results of our past performance somewhat incorrectly.
People tend to take too much credit for their successes and blame external factors for their failures. This in turn breeds overconfidence, and overconfidence leads to more trading. But the good news is that, over time, experience kind of steps in, and people get a little bit more better calibrated as to their actual skill level. Why is it so important that traders get this right and really understand what’s driving their success and what’s driving their failures?
RANDY: Well, there’s an old expression that says, “Don’t confuse a bull market with trading skill.” As you know, with the exception of the very brief bear market we experienced back in February and March, we’ve essentially been in a bull market for over 11 years now. And that means that virtually any investor under the age of 30 has really never experienced a normal bear market.
I think it’s human nature to want to be right, so it’s natural that we want to blame others for our failures. Unfortunately, you can blame anyone you want—it’s still your money that got lost. And as you know, Mark, we learn a lot more from our failures than from our successes, but those who don’t learn from their failures, of course, are far more likely to repeat them. Anyone who’s been a trader for a few years is going to experience a losing trade, and it’s important to analyze what went wrong, so you can try not to let it happen again.
You’ve probably heard me say this before—most traders probably think they have a high tolerance for risk, until they encounter a true bear market. Then they realize that their risk tolerance is probably a lot lower than they thought.
MARK: Randy, I think this is another example of where probably most people listening, they heard what you just said, it makes a lot of sense to them, but actually fixing it, in the real world, very difficult. So any particular techniques that you’ve found that are helpful?
RANDY: Yeah, I think there’s two ways, two key ways, that I like to look at that I think are very helpful in dealing with this issue, and they kind of echo some of the comments I made earlier:
- The first one is, I always advocate that you should have at least 80% of your overall portfolio in long-term investments. And as we talk about all the time, those only need to be rebalanced once or twice a year. What that means is that you’ll be limiting your active trading portion to only about 20% of your portfolio. No one should ever be trading actively in their entire portfolio.
- Now within that 20% that you use for trading, then limit each individual trade to no more than about 5%. What that does is, it makes sure that you never get too concentrated in any one position, in any one type of strategy or any one trade.
Look, everybody makes a bad trade every now and then, and anyone who invests for a decade or longer is going to eventually experience a bear market. These rules, I think, can help you survive both, without putting your long-term portfolio at risk.
MARK: What I like about those suggestions is, I think we see that pretty consistently among a lot of clients where they, in effect, do a little mental accounting, and they have their trading money and their longer-term investing money to try to make that happen, so that suggestion is really resonating with a lot of people, and that’s good to hear.
Another important decision that investors have is when to take profits, when to take losses. Arguably that’s maybe the most important decision. Many studies show that investors are far quicker to realize gains than they are to realize losses. And in fact, this tends to hurt their performance. One study actually created this artificial trading environment where they made it, in fact, more difficult for investors to see the cost basis of the positions that they were trading, and the magnitude of this effect to realize profits too quickly and let losses run too long—they actually reduced the impact of that bias by 25%. So, from your standpoint, how do investors … how should they go about reducing their obsession with the purchase price?
RANDY: You know, there’s this old investing axiom that says, “You can’t go broke taking a profit.” And while there is plenty of truth to that statement, I think the point you’re trying to make here is that you might also be leaving a lot on the table.
So many traders think in terms of, “I’m either all in, or I’m all out.” We hear it all the time when the market starts to look a little toppy, we get all kinds of questions about whether it might be time to “get out.” When I hear that statement, it implies to me that they want to sell everything and go 100% into cash.
My response to that question is always an unequivocal no. Going 100% into cash is a bad idea today, it’s a bad idea tomorrow, and any time you ask me. I’ll always give you the same answer, and there’s really two key reasons why:
- First of all, it’s very, very unlikely that today is the absolute top of the market, and even if it was, it’s highly unlikely that it would be the top of the market for every single one of your positions.
- Secondly, once you go into cash, who’s going to tell you when it’s time to get back in? And even if they did, would you listen?
I would argue that you probably wouldn’t, and here’s why: Because the opportune time to get back in would be at the exact bottom of the bear market. Not only is that impossible to predict, but when it does happen, bearishness is usually at a peak, and no one wants to be buying at that time.
So let me give you some examples. Think back again to March 23 of this year. The S&P 500 had just fallen 33% in only a month; buying on that day would have earned a 65% return in only 8 months. If you were 100% cash at that moment, would you have put it all into the market on that day?
Likewise, go back to March 9 of 2009. The S&P 500 had fallen 56% over the course of 17 months. Not only were very few investors interested in buying at that point, many were actively selling at or near the bottom. From that point forward, the S&P 500 gained 80% over the next 13 months and 400% over the next 11 years.
MARK: Yeah, it’s really difficult to, you know, time those entry and exit points perfectly. But for some people, that’s what they think investing is all about. And if you’re adopting that kind of “all or nothing” mindset, you’re really setting yourself up for failure, and let’s face it, if the game is unwinnable, you should ask yourself, in fact, whether it’s worth playing.
RANDY: Yeah, and some people do, and unfortunately they leave the market and never come back. I think one way to help solve this problem of buying at the bottom and selling at the top is to just stop trying to. Few traders can do it with any continuing success, but if you can just get anywhere close, you can actually still do really well.
So if you think the market is getting a little too high, scaling out of positions slowly, depending upon how the price changes, can be a very effective strategy.
So let me give you an example, because again, this is something that I’m pretty passionate about. Let’s assume that you own 1,000 shares of XYZ, and you believe the market’s getting close to a top, consider just selling 100 shares. If the market moves a little higher in the next few days, sell another 100 shares. And then each time the market moves a little bit higher, sell another 100 shares, but if the market falls down a little bit, goes down, then don’t.
If the market moves generally higher over the subsequent days or weeks, eventually you will have sold all 1,000 shares at progressively higher prices. However, if the market peaks and begins to decline before all of your shares are sold, you may still own some shares, but any risk due to that decline will have been greatly reduced by the fact that you own less than 1000 shares.
Scaling out of a position has the potential to leave you feeling pretty good no matter what the outcome. And if you want to really simplify it even further, just do it this way: If you think the time sell is right, sell half your position. Now let’s look at that.
If you sell half your position and the market moves higher, you’ll be happy that you still own 500 more shares. If you sell half your position and the market moves down, you’ll be happy that you sold the first 500 shares before the price declined, and you’ve locked in those profits, and now you’re only losing half as much on the other 500 that you still own. Either way, unless you are extremely good at picking the exact top and the exact bottom, you’ll feel pretty good about your decision.
MARK: Randy, you were talking earlier about your trading plan. At what point do you kind of go back to that and kind of rethink the reasons why you bought a stock or opened a position in the first place?
RANDY: Well, you know, when it comes to deciding when to take losses, it depends on why the stock went down. If all the reasons for why you bought the stock in the first place are still valid, well, holding on to it may be the right strategy. But if the reason the stock went down is because something new came up that wasn’t known back when you first bought it, then it may be time to cut your losses and just move on.
In other words, if you didn’t already own it right now, would you buy it? And if the answer is no, then it’s probably time to sell.
MARK: Thanks for your time today, Randy. Good information as always.
RANDY: My pleasure, Mark. It’s always great talking trading with you.
MARK: Randy gave us a lot of good advice to keep in mind, but I want to highlight two questions you need to ask yourself before you make a trade.
The first is, why are you getting in?
You buy a stock because you think it’ll be a good investment. Nobody makes an investment planning to lose money.
But how exactly do you expect this particular stock or trade to make a profit for you?
Is the stock going to increase in price because there’s a lot of momentum behind that stock that is pushing its price higher?
Is the stock poised to generate robust growth in revenue, and earnings will follow?
Is the stock simply too inexpensive right now given the company’s assets, and once others realize this, it’s price will start to rise as well?
Once you’ve figured this out and you’ve identified the stocks you intend to purchase, then you can map out a smarter trading plan. Settling on a trading strategy up front and being aware of your own bedrock set of trading principles can help you avoid disappointment down the road.
And that leads to the second question: How are you going to get out? Part of any smart trading plan is planning for an exit—regardless if the strategy works in your favor or not.
One final thought before I wrap up that I think is particularly applicable right now. We’ve all heard the expression about “jumping on the bandwagon.”
People join bandwagons because it feels good to be on the “right” side or to “win.” If you get the feeling you are about to hop on an investing bandwagon, try to train your mind to think like a contrarian.
Investing in something just because of bunch of other people are investing in it is a weak reason to jump in. Do your own research and seek out opposing points of view of smart people who aren’t on the bandwagon. Often you’ll find that your initial impression of a stock is tempered by reading a variety of viewpoints.
If you’d like to learn more about Schwab’s intuitive trading tools, educational materials, and zero commissions on online equity trades, check out Schwab.com/trading.
And you can learn about specific trading strategies by checking out Schwab’s YouTube channel. There we have videos about combining indicators, short selling, pivot points, and many other trading topics.
That’s Youtube.com/CharlesSchwab. While you’re there, be sure to click the Subscribe button so you don’t miss a thing.
Thanks for listening.
To hear more from me, please follow me on Twitter @MarkRiepe. M-A-R-K R-I-E-P-E. And you can also follow Randy Frederick on Twitter @RandyAFrederick.
We’d also appreciate it if you could leave us a rating or review on Apple Podcasts. It helps other listeners discover the show.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.