Friday, August 1, 2008

Cognitive dissonance in trading

Just as I was on a little winning streak trading, I ended up doing something really stupid today. However, I did notice that this stupid trade that I made today is very similar to other stupid trades that I've made before and might be rooted in something psychologically ingrained in all of us.

Basically, the stupid trade looks like this. I have a premise/trade idea that is a combination of a short/medium term catalyst. After entering into the trade, I exit the trade for whatever reason (profit-taking, short term catalyst gone, time spent in trade, etc.). As the stock continues to move in the direction I had predicted, I now don't look for reasons to get back into the trade in that direction, but rather start to look for a fade move against it. This usually leads to much much pain.

An example: Let's say I buy a stock at $10. As it gets to $10.25, I notice there is a seller that keeps holding it down. Not only selling at $10.25, but coming low to $10.20, and seeming to return even after that one order is done. Seeing this new seller, I decide to exit the position, thinking supply/demand is saturated here. After a bit of time passes, either the market or just the stock proceeds to continue the move with speed and force. Before I can decide to join in again, the stock is at $10.50 and beyond. Now, however, I often find myself rationalizing a viewpoint to fade the move. Thoughts like "the stock has just made a 5% move" or "I think that's the seller coming back in" tend to just lead to a lot of pain as I keep getting squeezed through $11 and so on.

Now, obviously I traded like a moron. But I'm beginning to wonder whether part of what's behind the thought process comes from cognitive dissonance. I did a quick example of cognitive dissonance in this random daily thought from over a year ago: RDT Post
In short, cognitive dissonance refers to the mind's need for our thoughts and actions to be consistent (ie. not contradictory).

I don't recall the exact study, but I remember my professor describing a study about cognitive dissonance: Subjects were asked to do a task on a computer. The task was extremely boring and repetitive. After the completion of the task, subjects were paid either $1 or $20 for their participation. After receiving the payment, subjects were asked how much they enjoyed the task. According to the results, the subjects who received $1 on average responded to having enjoyed the task more than subjects who received $20. The authors' conclusions were that their minds experienced dissonance from performing such a boring task for only $1 that they resolved the contradiction by believing the task to be more enjoyable.

With regards to the trade, I'm wondering whether I start to think about reasons why the stock would come back instead of keep on going because it's consistent with me having exited my position earlier. Now, if cognitive dissonance was really such a factor, noone would sell their positions because it's contradictory to them buying it in the first place. However, in this case I had two contradicting beliefs already (the buy and the sell) and it seems that the most recent one had more sway over my thought process.

Oh well, whatever, maybe I'm just a moron who can't trade and am just whining. Have a good weekend everyone.

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