Emotional Intelligence and the Trader
Why is it that 90 percent of traders who trade the markets fulltime fail to earn an adequate return even when using systems claiming 70 percent accuracy? Perhaps it is because traders do not recognize the importance of the Paramouncy Principle.
The Paramouncy Principle suggests that you are the most important variable in the trading equation. Not you, the dispassionate arbiter of
technical and fundamental analysis, but also you, the thinking, feeling, sentient being with all your human foibles, hopes and aspirations. Most traders lose money because they do not have an understanding of the markets or of themselves.
They trade without method, strategy or discipline. They fall prey to powerful emotion that leads to impulsivity and behaviors more akin to gambling than to genuine understanding. They give in to perceptual biases that lead to false conclusions and inappropriate actions.
Most Traders Focus on Method
A wide educational curriculum is crucial in addressing the Paramouncy Principle, yet most traders prefer courses on technical analysis that concentrate on method but neglect money management and mental processes. A quick perusal of the popular courses available confirms this view.
The predilection by traders for learning technical or fundamental market analyses at the expense of other important areas is not new. During the early 1900s, Jesse Livermore ? the legendary character in Reminiscences of a Stock Operator by Edwin Lefvre ? realized that his peers overrated the value of charting (See P61). Even great technicians like W.D. Gann and Richard D. Wyckoff are advocates for the development of method, the application of discipline and the importance of money management. Yet even armed with this understanding, traders have the daunting task of identifying the psychological factors that lead to self-defeating behaviors.
Emotional Intelligence ? More Psychobabble from Psychologists?
For some, the importance of emotional intelligence to the development of investment skills is considered irrelevant. Yet those are precisely the personal attributes outlined in Figure 1 that will sustain, inspire and motivate the trader during times of duress. Emotional intelligence is as important to the trader as is traditional IQ. Those who think back to their school days will recollect that there were a number of students who always seemed to get As and Bs and probably just as many who got poor grades or failed. However, we also all probably know that many of these so-called ?less intelligent? students now have very successful businesses or have received public acknowledgement for their contributions to the community or society. They may have more affluence in its widest sense and in terms of personal happiness than those so called more intelligent students. The reason for these anomalies is because academics, teachers and research psychologists have ignored the value of emotional intelligence until recent years.
There are many domains and related competencies subsumed under the title of emotional intelligence, and a number of personal qualities relevant to traders are:
- The ability to control impulses;
- The ability to delay gratification;
- The ability to motivate oneself;
- The ability to persist in the face of frustration;
- The ability to regulate moods;
- The ability to keep worry and fear from thwarting the decision process during times of duress;
- The ability to empathize with others; and
- The ability to not lose hope and to communicate hope to others.
By permission of Dan Goleman
Goes Back to the Greek Philosophers
These are the types of qualities that enable a trader to succeed where simply more cognitive intelligence will not be of singular value. We all experience emotions but sometimes find it difficult to understand what their role and purpose are. Ancient Greek philosophers laid the foundations for modern European and American psychology of emotions.
Plato (427 to 347 B.C.) wrote popular and influential philosophic writings consisting of a series of dialogues in which the discussions between Socrates and others are presented with erudition and charm. Plato thought that emotions were like drugs; they pervert and distort reason. This assumption influenced the thinking of Victorian scientists and still permeates the beliefs and attitudes of traders today. For example, the works of evolutionary biologist Charles Darwin and American psychologist William James imply that emotions are merely biological events like a cough or a sneeze with no meaning and that they are the opposite of thinking.
Aristotle (384 to 322 B.C.) is the best known of Plato?s students, and his contribution to the understanding of emotions is significantly different than that of Plato and more in line with the findings of scientific research into emotions. Aristotle?s most fundamental insight was that emotions are connected with action and that they derive from what we believe. Aristotle?s book, The Nicomachean Ethics, is a philosophical inquiry into virtue, character and the good life. Our passions, when they are exercised, have wisdom, and they guide our thinking, our values and our survival. But they can easily go awry and often do so. Aristotle?s view was that the problem is not with emotionality, but with the appropriateness of emotion and its expression. Aristotle?s challenge is to manage our emotional life with intelligence.
Traders hold contradictory beliefs regarding the value of emotions. On the one hand, they act as the foundation for heroic and compassionate deeds, and on the other, they act as destructive forces that can cause self-sabotage during trading, faulty reasoning, war and destruction.
Not only do we have a contradictory belief regarding emotions; the well-worn phrase ?emotion kills successful trading? is inculcated into the psyche of the novice trader.
Contemporary scientific evidence shows that emotions are central to establishing, maintaining, changing or terminating the relation between a person and the environment in matters of significance to the person. Emotions now are viewed by the scientific community as both functional and indispensable to rational thought. The effect of moods and emotions on judgments is significant, and traders make judgments by combining how they feel with what they know.
The Need for a Model of Investment Competence
There are very few occupations that require the determination, strength, courage and integrity of beliefs as does trading. Traders have only their knowledge and courage ? in essence, we are on our own before the computer screen. There is no external examiner or line manager to help. There are tools such as the computer, helping to analyze the market, charts that may plot strengths and weaknesses or resistance and support. Traders may have a fast order entry system giving depth of market, and market maker (Level 2) information. The final analysis is that, for many, it is a solitary pursuit without the immediate or the informal support of colleagues. In these circumstances, it is essential that traders have a comprehensive model of trading competence to guide them.
The Paramouncy Principle embraces the holistic notion that a trader can develop a range of skills over time to address all aspects of the person required to succeed in this difficult profession. In my book, Financial Risk Taking, a comprehensive model of trading competence is presented to outline tactical (active trading) and strategic (planning and learning) skills requirements. See Figure 2 below.
In addition to the comprehensive model of trading competence, eight standards and related criteria are presented in the style of a workbook to assist the trader to structure and facilitate learning. If traders can identify their weaknesses and strengths, they will be taking the first steps to trading competence.
Following a number of years assessing my own strengths and weaknesses as a fulltime, home-based trader, I examined research in cognitive psychology and economics, applying theory to practice. The eight standards and criteria of trading competence were developed following interviews with 38 home-based traders who identified critical areas of their own learning and development.
The Eight Standards and Criteria
|Standard 1 ? Market Analysis|
A mastery of one system or methodology based on observable outcomes. My personal preference incorporates trading volume in relation to price spread using Wyckoff methodology and related tools, such as tradeguider.com.
|Standard 2 ? Stress Management|
|To identify external stressors, understand its effect on performance, and apply a method of stress reduction on a daily basis. My personal preference is walking, cycling and employing deep-breathing techniques effectively.|
|Standard 3 ? The Trading Business Plan|
To place in writing a plan that reflects decision processes, financial and risk management strategies, and rules of market engagement. Successful investors without exception have written rules of discipline and market engagement, and review progress regularly at designated periods, often marked on a calendar.
|Standard 4 ? Perceptual Biases|
|To bring into conscious awareness the negative influence of predispositions, beliefs, and common errors of
judgment. For example, investors? are afflicted by the common error of giving a greater value to information supporting a position than information against it.
|Standard 5 ? Emotional Biases|
|To understand the value of emotions, identify negative emotions, and learn techniques to control moods and emotional states. Some investors may need outside assistance to identify recurring negative emotional states during active investment. The use of modelling and cognitive behavioural therapy has had tremendous success.|
|Standard 6 ? Financial and Risk Management|
|The ability to perceive, define, and manage risk. Investors need to keep written records in the form of a trading diary, decision diary, and equity chart. A statement on how the written diaries and charts will be created and then utilised can be added to the business plan.|
|Standard 7 ? Data Management|
|Developing personal strategies to manage information. Having a general understanding of hardware and software, being at ease with basic arithmetic, and identifying the difference between relevant and irrelevant information.|
|Standard 8 ? Continuing Education|
|Creating a personal training plan using information about strength and weaknesses learned through using these Standards and Criteria or similar. Identify target dates for completion of learning tasks and assess outcome. Continuing education is a lifetime pursuit and setting higher goals in a structured manner will facilitate learning and keep you in touch with your aspirations.|
The Planet of Market Wizards
Perhaps the strongest evidence in support of intelligent life existing in some distant corner of the universe is that they have not contacted us. Traders lose money by repeating mistakes time and again and view these blunders as business expenses on the road to market mastery. They look to self-professed experts for guidance, some of whom hold no qualifications apart from a certificate in audacity and the ability to convince people that they hold esoteric knowledge providing a conduit to wealth and prosperity. Who can question their integrity when the very nature of investment is based upon an unpredictable market open to interpretation? The corner shop vendor will tell you of his trading profits with an anecdote regarding earlier failures, adding realism to the events. The bus driver, professor, tailor, surgeon and refuse collector are all market wizards.
The dream of easy success has been sold to people throughout the ages, and the current boom in sales of software and investment courses holds disquieting historical parallels. In Amsterdam, Holland, during the sixteenth century, there was an accredited course in alchemy from a respected center of education. An historical ancestor of the British, Dr. John Dee ? mystic, astrologer and advisor to Queen Elizabeth I ? is reputed to have researched alchemy there. No one had ever turned lead into gold, and we now know that turning lead into gold does not fit the facts of empirical quantum mechanics and inorganic chemistry. Regardless of the lack of evidence, it did not change the fact that people believed it could be done. This belief existed for almost a thousand years. Great halls were filled with people, and if you could convince somebody that you had done it once, people would pay large amounts to learn the secrets of alchemy.
Traders believe in the authority of expertise, and stockbrokers and financial advisors are trusted with the money of hardworking people. Numerous studies show that advisors on equities consistently do worse than the markets in which they are involved, even before making allowance for any fee. The same applies to the managers of pension funds, unit trusts and of the portfolios of insurance companies. Some traders are targeted by brokerages as potential clients to exploit. I have been subject to numerous cold calls and recently recorded an attempt by a broker to sell me a ?great market opportunity.? The broker was unable to answer the most basic questions about how he and his market analyst arrived at their conclusions.
But It Can Be Done
Having discussed the downside of market investment, there is also an optimistic and rewarding element. There are many traders who make regular profits from their homes and brokers who are highly skilled and committed to providing a quality service. A common attribute of successful traders is their belief in the Paramouncy Principle ? whether they call it by this name or not ? and the personal responsibility they take for all investment decisions. Trading success requires a set of skills that enables traders to think clearly under stressful conditions, to make intelligent decisions devoid of perceptual and emotional biases and to keep control of money in their account. The Paramouncy Principle makes explicit the requirement of self-awareness and self management, two important (yet neglected) domains of emotional intelligence.
The journey to investment competence is a challenging yet potentially rewarding path, and we may see things of beauty along the way. It is inevitable that traders will experience loss and fear, frustration and self-doubt; but it is how these events are perceived and managed that determines a place among the 90-percent majority or ten percent of profitable traders. Are you ready to accept Aristotle?s challenge?