The Psychology of Trading

As a hedge fund manager, it is intriguing to watch my investor’s reactions to their account performance. Sadly, clients often make terrible choices in their entry and exit decisions. Even though they are using the services of a professional money manager, they drastically alter their results by their own timing decisions.

Without a doubt, the single biggest problem is the tendency for clients to chase performance, the grass is greener concept. Most often investors are hungry for recent performance and tend to want to invest with a manager who has had a strong round of recent performance, and they will tend to shun talented managers who might not have had recent, exceptional performance.

The problem with this strategy is that statistically it tends to fail. Good managers who have recently been “hot” are usually due for a setback, and quality managers who are in a temporary slump represent some of the best potential plays. As billionaire investor Warren Buffet says, “The time to get interested is when no one else is. You can’t buy what is popular and do well.”

Market Wizard author Jack Schwager furthered this conclusion. He did a study showing that the best allocation system between money managers included periodically re balancing the equity between all the managers. In essence, the winning managers pay a penalty by having their equity reset back to an equal percentage of the pool, and the losing managers get rewarded by the same mechanism.

Awarding the losers and penalizing the winners this way does not imply that investors should invest in a manager JUST because he is losing. It is possible it is simply a poor manager who will never recover. The idea is to find sound managers who are only going through a temporary setback period.

Theoretically, many investors would agree with the above advice, but how many of them are able to jump in full force with a manager who has recently been in a slump? This is where proper psychology comes into play.

Legendary Market Wizard Bill Eckhardt and partner of the infamous “turtle trader” Richard Dennis referred to this in a recent interview when talking about teaching the turtles. He said: “Attitude, emotional control, discipline; those things are harder to teach. All the turtles learned the system and learned the strategy; that was the easy part, but some of them brought the right attitude and right mental set to it and they prospered and became very rich. Others had a more halting career and did not succeed as well. They had the same training, but maybe they did not have the same emotional make-up.”

It is somewhat contradictory advice for trend followers to buy a manager who is in a dip. After all, their training tells them to buy strength and sell weakness, but when timing a trend following manager we believe that it makes more sense (and the data confirms) using a counter trend approach to buy a manager who is in a short, temporary dip within a longer term uptrend.

Dean Hoffman

Past performance is not indicative of future results. Commodity trading carries risks and is not suitable for all investors.

Learn more about award winning hedge fund manager Dean Hoffman