August 25, 2015    5 minute read

The Psychology of a Trader

   August 25, 2015    5 minute read

The Psychology of a Trader

Investment banks and trading firms are spending large sums of money to help improve the psychology of their traders to help avoid catastrophic collapses such as that of Kweku Adoboli at UBS. Kweku Adoboli was a trader who lost UBS over £2bn through unauthorised trades. The losses came as a result of over trading in a bid to improve his position, consequently the situation spiraled out of control resulting in substantial losses. Adoboli said he:

“Absolutely lost control [and] was no longer in control of the decisions around the trades we were doing”

Theories and studies into behavioural finance and trading psychology have helped narrow down what the ideal psychological requirements of a trader are.

Prospect Theory

This is a major economic theory which aims to model the decision making of traders in a risk environment. It indicates that people have different attitudes to the prospect of potential gains and losses. A key feature of this theory is an introduction to diminishing sensitivity. This means the further away a variable is from a reference point the less we value its impact. For example, if you had £10 and lost £5 it would seem like a larger loss than if you had £100 and lost £5 but the £5 still holds the same value. This is illustrated in the graph below where one can see that in relation to gains and losses, the value diminishes the further away from the reference point of zero you get.

Prospect theory graph

 

A simple survey was completed which consisted of two questions:

In addition to whatever you own you have been given £1,000 and you have to choose one of the following, which one would you choose?

 

Choice Results
A 50% chance of gaining £1,000 16%
A certain gain of £500 84%

 

In addition to whatever you own you have been given £2,000 and you must choose one of the following, which would you choose?

 

Choice Results
A 50% chance of losing only £1,000 69%
A certain loss of £500 31%

 

The results showed that most people prefer not to lose at all. This shows that people can behave irrationally when facing losses and therefore may help explain why Kweku Adoboli lost so much money for UBS. If at one stage he was making a loss of £1bn, what would a further loss of £1 million mean? It could seem like an insignificant amount compared to £1bn. This key theory is applicable when dealing with losses. Traders must be cautious when facing losses and should be wary of diminishing sensitivity in their trades. Traders risk losing substantial sums of money all because they value losses differently.

Herd behaviour

This type of behaviour demonstrates a tendency of individuals to copy the actions (rational or irrational) of a larger group of people. A prime example of herd behaviour arises in trading Oil. In 2008 to 2009 experts around the world stated that the world supply of oil is rapidly depleting. This caused many investors to take long positions on the news as crude oil was expected to rise as a result of a decrease in supplies. This is exactly what happened as shown in the graph below.

WTI Oil Graph

 

A possible reason causing herd behaviour is that just like in society, people have the desire to conform socially. Another reason is the strong possibility that the larger group of people are right. If a trader in 2008 had placed a sell order at $100.00 they would have been branded a fool. Yet as we can see ‘the herd’ can be a very powerful factor and helps explain why investors trade the way they do. If a large group is doing one thing, it may be a good idea to follow it but unfortunately they are not always right.

Investor bias

Bias towards your own particular opinion or view is very common in trading as it is with normal life outside of trading. In football, people will filter out negative information and opposing viewpoints against their team therefore focusing on positive information. This is no different in trading where investors will filter the information to match their viewpoint. Investors who are excited about a stock will have a positive bias when researching that stock which means they will be rationalising the negative information. If an investor is unable to understand the opposing view then it can contribute to substantial losses as markets won’t always reflect your viewpoints and the opposing opinion may prevail.

Dealing with failure

The big question for traders is whether they can accept the fact that they may make numerous losses. Some cannot accept this fact. A lot of individuals are incredibly successful in most areas of their lives and so have never experienced a tough failure and therefore, they may not know how to deal with it. A trader facing losses with the right behavior and psychology will always know when the right time to exit a position is, if their losses are mounting. They also will not let a bad trade negatively affect them and they will almost always persevere, turn things around and make a profit. Sir Winston Churchill was once quoted saying:

“Success consists of going from failure to failure without loss of enthusiasm”

Financial markets are ruthless and unforgiving, so it is a trader’s ability to deal with the acceptance of failure that can make them truly successful.

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