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Freudian Trading Techniques
By Price Headley | Published  12/9/2005 | Stocks , Options , Futures , Currency | Unrated
Freudian Trading Techniques

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When I was in college, I had a class in investment analysis. On one particular occasion, we had a group project which consisted of selecting a stock and then giving a recommendation on it. We chose a technology company whose earnings were shot and whose outlook was dismal. As we were deciding on what recommendation to offer, I suggested that  the stock was headed down and that we should recommend a sell. One of the gentlemen in the group immediately replied that he thought we might sound stupid for picking a stock and then recommending to sell it.

That's when it dawned on me that the ego affects stock selection, evaluation, and recommendation significantly. I told this fellow that the data suggested that the stock was a sell. I also reminded him that the OBJECTIVE of the project was to a evaluate a stock, not to pick a winner. After some thought, I recalled that many analysts viewed the industries which they evaluated as THEIR industry. In doing so, those same analysts were often bullish much too often, including times when it was totally unprofitable to be bullish.

Mine is Better Than Yours

Another example is when I went for an educational seminar. There was no selling whatsoever and it was strictly educational. There were teachers from fixed income, equities, and real estate. Each speaker spoke about how the investment they were discussing was the best performing asset class in history. It was ridiculous but very illuminating. Individuals become emotionally attached when they use the word "my". "My shoes, my car, my profession, and even my stocks are superior!" Then, I began wandering how detrimental this sort of thinking was. It eats away at profits and increases losses!

As I flipped through pages of magazines recently, here is what I saw. On the cover of a real estate magazine, I saw the heading "capitalize on the boom". On the cover of a stock broker industry magazine, I saw "protecting your clients from the impending real estate bubble". Each industry seemed focused on itself and more importantly, was bullish on it's own industry. This emotional attachment that we often fall into is total hogwash! It is counterproductive and totally subjective. So how can we use this in our trading? First of all, we must recognize that this phenomenon exists. Watch out for the word "my". The truth is "my" portfolio does not consist of "my" stocks. They are just anyone's stocks and what matters is how they are performing and how they are likely to perform. That's where the focus should lie at all times. That is why the most common investing mistake over and  over is holding on to losers much too long. It is an emotional decision. Avoid this at all times.

Objective Testing

This phenomenon also applies to system building. I was testing an indicator recently and found that it was an excellent indicator both in the short term and long term. A week later, I found out that  while I was testing, I made a clerical error of buying on bearish crossovers instead of bullish. In other words, my data was corrupted and my original conclusion was most likely wrong. I was disappointed. "My indicator" was not worth as much now. But the point is, it's not "my" indicator at all. It's just simply an indicator that I was testing and I must remain objective. That is the key. While system testing and holding on to trades, traders must remain objective. Here is a way to ensure this: Decide before testing systems, what level of profitability you want and what sort of win/loss ratio you are looking for. In other words, describe in writing what sort of numbers a system needs to hit in order to adopt the system. Then start testing. The one or ones that fulfill your requirements are the ones you should go with. Otherwise, you might fall in love with a system for the wrong reasons. You'll also be able to tell the difference between a good system and an oustanding system.

This article is was named "Freudian Trading Techniques" because it involves the ego and shows how the ego forces individuals to become biased and irrational. To sum it up, save yourself thousands by adhering to these principles:

  • Remember the stocks in your portfolio are not your stocks. They are simply publicly traded securities which need constant evaluation
  • Being sharp enough to sell or pass up a loser is a strong action to take, not a weak one
  • Stay objective and completely detached when testing systems and when making trade decisions
  • When testing systems, lay out the characteristics of a good system before testing. Only use the systems that fufill or exceed the characteristics

Be disciplined, and trade well!

Price Headley is the founder and chief analyst of BigTrends.com.