Barry Ritholtz has an excellent post up this morning (as usual). This one makes an excellent distinction between trading and investing: “Trading (as opposed to investing) is more about laying out probabilities of risk versus reward; Investing is about valuations within the longer secular macro picture.” About this I can only agree wholeheartedly and move on.
He then goes on to examine the roles of those well-known (if not so well understood and even less so well controlled) emotions of fear and greed:
By the way, that is a little known element about Greed & Fear: Greed is actually a variant of Fear — the fear of missing the move higher, fear of leaving profits on the table, fear of losing clients, fear of lower income, fear of losing your job. Hence, when most people say that Fear & Greed drives the market, they are really saying FEAR drives the market in both directions. True Greed doesn’t come into the picture, IMO, until we get to the stupid phase — think DotComs circa 1999 or Housing circa 2005.
I have a five-and-a-half month old grandson. When Aiden thinks something fun is going on or even might go on, he will resist taking a necessary nap with every fiber of his being. In our family, we say that he is suffering from FOMO — fear of missing out. FOMO is exactly what Barry is getting at here. But I also think that Barry is leaving out something important.
Fear and greed are frequently trumpeted as the twin drivers of markets. I have long contended that there is a third driver and one that is underappreciated: ego. Ego often pushes us to do things we might not do otherwise (and vice versa). I’ll show them. I just know I’m right. Mine is bigger than yours.
Profitable trading takes great conviction, perhaps even great ego, but one can “fall in love with” his position or “marry” her bias to great detriment.
Humility isn’t easy for anybody. It’s especially difficult for those who are successful, driven and competitive and this business attracts those types of people and rewards those types of people. But humility can protect us from ruin. As Stanley Druckenmiller said about George Soros (in The New Market Wizards : Conversations with America’s Top Traders), “I’ve learned many things from him, but perhaps the most significant is that it’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.”
There are no absolute sure-things in the investment world. Trading successfully means properly analyzing the probabilities and acting accordingly. Every good trader is going to be wrong a significant portion of the time. There are simply too many variables in the system for it to be otherwise, especially because so many of those variables are unknown and even unknowable (think Frank Knight’s classic distinction between risk and uncertainty).
As Michael Mauboussin puts it in his book, More Than You Know:
So how should we think about risk and uncertainty? A logical starting place is Frank Knight’s distinction: Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like. So games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain. Knight said that objective probability is the basis for risk, while subjective probability underlies uncertainty.
A clear and objective process (to the extent one is possible) can help to guard us from letting our egos run away with our good sense. The markets are humbling. Sometimes it behooves us to “take our medicine” and move on.