The Definition of Madness

The Definition of Madness

We often read that the definition of madness is doing the same thing over and over and expecting a different result. The implication is that if something isn’t working, change it and change it again.

It turns out for traders and investors, life may not be as simple as that.

According to London-based Essentia Analytics, they need to be careful when they’re on a winning streak, but they need to be really, really careful when they’re on a losing streak.

They recently concluded that professional fund managers largely ignore Rudyard Kipling’s advice about treating those “two imposters”, triumph and disaster, the same.

Instead, their behaviour changes both when they’re on a roll and when everything is going wrong. And it doesn’t change in a good way.

The firm examined 250,000 trades and uncovered some simple truths and some uncomfortable ones. The simple truth is that you should expect winning and losing streaks. Not earth shattering. It happens.

But over 10 years of data, Essentia found that half of active fund managers show significant changes in behavior after a five-day winning or losing streak.

When on a winning streak they turn more cautious – making fewer decisions, fewer trades and smaller trades. Now that’s not a great thing to do, but it’s not killer.

The real harm is done following losing streaks.

Professional investors are almost twice as likely to change their behaviour after a losing streak than a winning streak, and not in a good way.

They trade more often, with some managers trading three to four times as much when losing. They make much bigger decisions and much bigger trades: managers that increased their trading size did so by nearly doubling their daily turnover.

In other words, many professionals act in a highly emotional way after losing streaks and this hurts performance.

Why? Psychologist Daniel Kahneman won the Nobel Prize in economics for his insights into loss aversion, people’s tendency to prefer avoiding losses than bagging equivalent gains.

Kahneman showed that people typically reject a high-probability bet to protect existing gains but they will accept a low-probability bet to try to avoid losses.

The second reason, the paper suggests, is that investors are prone to an “illusion of control”. Again, this is a well-documented feeling where people tend to think they have a greater control or influence over circumstances than they really do.

Gamblers in a casino tend to roll the dice harder for higher numbers and softer for lower numbers; people prefer to choose their own lottery numbers than play with pre-chosen numbers.

When on a losing streak, investors “were instinctively acting as though the likelihood of the decisions they were taking being right was somehow significantly greater than usual”, say the Essentia researchers, “as though taking the view that not only is ‘it broke’ but that they could ‘fix it'”.

Firms like Essentia argue these results are proof of the need for active fund managers to become more conscious of the psychological forces that can hurt their investment performance.

A skeptic might say it would say this; the company does portfolio analytics for asset management firms and admits its insight service “doesn’t come cheap” – prices start at $80,000 per year, with the firm claiming it helps to boost clients’ performance by an average of 0.7 percentage points every year.

Regardless, a growing body of research confirms active managers’ investing decisions are frequently damaged by cognitive biases.

Unlike institutional investors, we are hardly likely to fork out tens of thousands of dollars to have someone analyse our trading decisions. In fact you won’t need to. Inteligex will enable us to do this by late 2019 if you are happy for us to have access to your trades and settings. We won’t just decode trades, we will decode you and what your appetite to risk is.

So what we’re saying here is be conscious that it’s perfectly normal to experience winning and losing streaks.

Changing your behaviour because of these random streaks – in particular, forcing trades in order to make up for earlier losses – is a bad idea that will cost you money.

Learn to trade with Inteligex. Learn what type of person you are. Stick to the plan. Attend the webinars. Ask questions. With Inteligex you are a member of a club. A club that is dedicated to its members. Together we can learn to trade better.


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