Sunday, May 3, 2015

Personality and Trend-Following

I would describe my approach to trading as research-based trend following. By that I
mean that I attempt to ride strength or weakness in the market after it has been
manifested. I do not, however, automatically assume that any trend is my friend.
Instead, I use historical research to distinguish between trending movements that are
likely to continue and those with a high probability of reversal. This is a highly
disciplined approach to trading in that it requires significant research and preparation
time, as well as an ability to stick with market movements and one’s game plan.
In my book The Psychology of Trading, I referred to personality traits that tend to
distinguish successful traders from less successful ones. Several of these traits are also
likely to influence the degree of success traders are likely to have in adopting a trendfollowing
approach to trading. Below are several self-assessment questions that might be
useful in determining whether you’ll face particularly great challenges in riding market
trends. Please write down “yes” or “no” answers to each of the twelve questions before
reading further:
1. When something goes against you in the market, do you often find yourself
venting your frustration?
2. Do you enjoy (or as a child did you enjoy) roller coasters or other thrill rides?
3. Do you often find yourself procrastinating over work?
4. Do you consider yourself moody—sometimes rather up, sometimes rather down?
5. Would you generally prefer going out and partying with friends rather than
staying at home with a good book or movie?
6. Do you often find yourself apologizing to others because you forgot to do
something you were supposed to do?
7. Are you generally high-strung, tense, or stressed?
8. If given the choice at a buffet, would you prefer to try exotic foods you’ve never
heard of rather than familiar dishes?
9. When you have a task that needs to be done around the house, do you tend to take
a quick and dirty approach, rather than a meticulous, painstaking approach?
10. After a losing trade, do you often feel guilty or get down on yourself?
11. Have you experimented with or regularly used two or more recreational drugs
(other than alcohol) in your life?
12. Are you often late for appointments or for social plans you’ve made?
If you indicated “yes” to most or all of questions 1, 4, 7, and 10, you most likely score
high on a trait called “neuroticism”. Neuroticism is the tendency toward negative
emotional experience, and it shows up as anger, anxiety, or depression.
If you responded “yes” to most or all of questions 2, 5, 8 and 11, you probably score high
on a trait called “openness to experience”. Openness reflects a tendency toward sensation
seeking and risk-taking.
If you answered “yes” to most or all of questions 3, 6, 9, and 12, you potentially score
low on a trait called “conscientiousness”. Conscientiousness measures the degree to
which an individual is oriented toward duty, responsibility, and dependability.
Other things being equal, the ideal personality pattern for trend following is one of high
conscientiousness, low neuroticism, and low openness. A good trend-follower will stick
with rules and systems (conscientious), won’t impulsively enter or exit trades on the
whim of emotion (neuroticism), and will trade for profits, not stimulation (low openness).
In my experience, some of the best systems traders are among the least flashy people.
They are meticulous and conscientious about their research and execution, and they don’t
let their emotions or needs pull them from their discipline.
Conversely, individuals who are high risk-takers and who crave novelty, stimulation, and
action often take impulsive and imprudent risks. Very frequently, the neurotic emotions
kick in after a series of losing high-risk trades. Such individuals are trading for
excitement and self-validation, not just profits. Even if they are given a tested, profitable
trading system, they will not be able to follow it faithfully.
System traders often focus their research and energy on defining the optimal parameters
for a system’s profitability. Equally important is finding a trading strategy that meshes
with one’s personality. Traders who are relatively risk-averse may trade shorter time
frames and/or smaller positions than those who are risk-tolerant. Traders with a higher
need for novelty and stimulation may benefit from trading a greater number of stocks
and/or markets rather than focusing on a relative few. Are some personalities simply
unsuited for trading? I would say yes, just as some personalities are not cut out to be
fighter pilots or surgeons. It is difficult to imagine a trader enjoying ongoing success
without the capacity for disciplined risk-taking.
It is not at all unusual to find that a trader is losing with a trend following approach
because he or she is acting out unmet personality needs in the market. One of the best
trading strategies one can employ is to find adequate outlets for attention/affection,
achievement, self-esteem, emotional well being, and excitement outside of trading.
Sometimes traders I talk with try to impress me by explaining that trading is their entire
life. They do not realize that their very “passion” and “obsession” with the markets are
likely to sabotage them, imposing undue pressures and interference. If you have a trading
system and you faithfully execute that system, trading should be reasonably boring and
routine. Better to enjoy roller coasters outside of market hours than ride them with your
equity curve!

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