You want to make money trading stocks. You have a decent system that makes money if you stick with your plan. Great. But sometimes you get that feeling of not being anchored, like you are just wandering in the woods. You are not necessarily lost – it’s just that the path has become a tad overgrown, covered with leaves, a bit more difficult to discern than before. Suddenly your trading begins to suffer, you take some losses, and, because you are a wise manager of risk who’s in it for the long haul, you realize that you are out of your element, so you exit all of your positions and take stock of what’s going on.
So what happened? Once you are out of all of your positions and you are back safely in the bunker, you take a look at your trades and have that inevitable ‘Aha! …duh’ moment. What you find is that you were trading your plan nicely in the beginning of the trend, but as the trend became further entrenched, the momentum got the better of you and you really didn’t stick to your strategy at all those last few trades. In fact, at the very end there you were trading like a complete amateur, you now see. “How could I be so stupid! Am I just an amateur,” you ask yourself. Now you’re in a bad place, questioning your abilities. Your confidence is shot.
Relax. Take a deep breath, do a few Stuart Smalley affirmations, and shake it off. Take another look at what went wrong. It was not your core strategy that was the problem – what screwed you up was your failure to stick with the plan. “If I had only” is all-too-common a refrain in discussions about investing. So why do we sometimes stray? The reason is that a person’s identity tends to become defined by their philosophies and actions – we therefore rationalize in order to maintain our view of ourselves if our ideas and actions are no longer functional in reality. I apologize for getting all Psych 101, but this is important stuff. This phenomenon is called cognitive dissonance, and it is crucial that all investors and traders understand its influence in order to succeed.
In no uncertain terms, cognitive dissonance can destroy your portfolio. You can rationalize your trades until your account is at zero. Take the example of big holders of GM. Let’s take the man who is 65 years old, bought GM in 1969 when he got his first real paycheck at age 25, and added to his shares every year until he was 60, reinvesting the dividends in new shares of the stock all along the way. He picked up a few other household names along the way, but GM would always be his first, his true love, his one and only. His GM position is now part of who he is – he’s had the stock for two-thirds of his life, longer than his kids have been alive. He has been married twice, has seen his four children grow up, get married, and have children of their own. He has seen the world change in ways he could hardly imagine in the last 40 years: he has seen three hot wars and one cold war in his country, he has witnessed the frightening and murderous consequences of the convergence of technology and terrorism, and he has seen the amazing advent of internet technology bring people together from across the globe who may never meet in person. And through it all, his GM stock has been there by his side. True, the stock has vastly underperformed the S&P and the Dow since he has owned it, but after the dividends he’s done okay. He has amassed 43,892 shares over the years. GM is part of who he is. So how does he react when the stock plummets 70% from 1999 to 2003? “Oh, well, I’m not worried,” he says. “It did the same thing in ’74 and was back near its highs in two years.” What about when the stock drops another 50% in 2008? “Buying opportunity of a lifetime, if you ask me.” And when it’s down another 50% and the company goes hat in hand to the government for a bailout? “They certainly can’t go bankrupt – it’d destroy the economy. And people still buy cars, anyhow – I see ‘em on the road every day. Don’t you? I’m sticking to my guns.” And on June 1, 2009, when…well, you know what happened last Monday.
…Painful, sad, and completely avoidable.
For some real-world examples of cognitive dissonance in action, let’s take a look at a few during the emerging bull market in 2003. The market had just suffered two years of declines after the biggest bubble in two generations burst into flames, sending the NASDAQ down nearly 80% from its highs. By May 2003, the market was trading in a wide 10-month range but had recently rallied over 15% since making a higher low eight weeks before. All of the major market indices had crossed above their 200-day moving averages by mid-April with the NASDAQ leading the advance. A Business Week interview with Comstock Capital Value Fund’s manager, Charles Minter, from May 7, 2003 reveals a disbelief and rejection of the emerging rally. Since Minter’s fund operated much like a hedge fund, so he was not forced to be a perma-bull, as he could short or buy puts as well as go long – he willfully chose to be in the bear camp at that time. Minter cites a bunch of fundamental reasons why the market should go lower (p/e multiples, job losses, low capacity utilization rates), never mentioning the super-bullish technicals that had recently emerged. He actually was right on his view of technology stocks, which he said would offer the best opportunities once the bear market was over. …And yet he proudly proclaims being short CSCO, IBM, INTC, KLAC, LLTC, and BRCM right in the middle of super-strong uptrends. Clearly Minter lacked the necessary tools to determine when the bear market had in fact ended. Regardless of this fact, he knew that these stocks had risen dramatically from their lows and that the broader market had resumed rallying after it failed to break down in early-March when it neared its bear market lows. And he knew that tech stocks – the very sector he was short – were outperforming the market since the lows. So the reality on the ground, by which I mean the prices of his stocks, was telling him that he was wrong, but he identified so strongly as being bearish that he was unable to adapt to the new reality, and rationalized away using flawed analysis of how the market would react to certain fundamentals. This is cognitive dissonance at its worst.
For full disclosure, having been in the financial business for a whopping two whole years at the time of the Minter interview, I was in the bearish camp too. “Every significant rally has been sold for the past two years, so why should this one be any different?,” I thought. I was short into June 2003 after the S&P had rallied 30% off its bear market low – that was the first time I learned about cognitive dissonance firsthand in the market, and I will never forget it.
Another example of cognitive dissonance can be found here in a newsletter by CPA Tim Wood, of FinancialSense.com, found later that same year. The piece was written on November 14, 2003, after 13 months of rallying and a 35% gain off the bear market low in the S&P500. In the newsletter, Wood talks at length about cycles, Dow Theory, market cycles, etc., and gives a brief summary of some historic trends going back to the 1920’s. Although lacking focus, there is some useful stuff in his comments. However, after carefully reporting what happened in the past, his argument boils down to an emotional response to the prior bull market and subsequent collapse, as he declares, and this is verbatim, “There is simply no way that a bull market advance of 2,061% that took some 26 years to complete was corrected in 3 short years. NO WAY!” …Who were you trying to convince, Mr. Wood – your readers, or yourself? The S&P then rallied another 10% in the following weeks, and never saw the November 14, 2003 level again until after it rallied a full 50% from the time of the newsletter piece. Cognitive dissonance strikes again.
The good news is you know how powerful, and dangerous, cognitive dissonance can be. You can now spot it in yourself and step away from the market when you recognize it. So when the current bear market is over, don’t fight it. Whether you use the 200-day moving average, the level of the prior bear market rally high, a weekly moving average, or whatever, to determine that the bear market is over, do yourself a favor and respect the new long-term uptrend. Same thing goes on the downside. If this market slices below the 50-day moving average after a false breakout above the 200-day, respect that emerging intermediate downtrend. Remember that the market does not have to do anything. It does not have to go down because the economy still sucks. It does not have to go up because the government is expanding the money supply. All the market has to do is open at 9:30 in the morning and close at 4 in the afternoon Monday through Friday. The market is the aggregate vote of all market participants averaged into one neat closing price each day, and unless you can personally affect where the market goes, you must respect the trend in order to trade successfully.
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