Tate on Trading - Plan for the Outlier Chris Tate Almost a year ago, events conspired in such a way as to send bushfires of unparalleled size and ferocity across Victoria. The time between then and now has been spent dissecting why the fires were so bad, our response so inadequate and how to avoid such an occurrence in the future. To the outside observer much of the analysis of these events seems to centre on the response to the fires and in particular the short comings of the existing planning. To a trader this is not an unfamiliar scenario since it seems the fires of last season could be referred to as 'outliers', That is, their appearance and magnitude is so extreme that normal mechanisms of planning were inadequate because no one thought that things could be so bad. If we cannot imagine it, then we cannot plan for it. Traditionally humans plan for events that they consider normal – this is to be expected. It is often said that military training centers on fighting the last war not the next. Training in all fields of human activity will be the same. We plan for what we think might occur within the boundaries of our own experience. The problem is - outliers are part of every system. As traders, the appearance of outliers is not unknown to us. Our trading is centered upon being in the position to take advantage of outlier moves in price. All traders dream of buying something at $0.10 and having it go to $50. Unfortunately most do not consider the reverse – buying something at $50 and having it go to $0.10. Yet precisely this situation arose during the meltdown in the global financial system that we are slowly emerging from. This was an outlier. A sequence of events so extreme that no one had considered it. It was considered impossible that you would get a collapse in equity markets, property markets (except in Australia where the Government perpetuates the bubble) and the US dollar. The interesting thing about such events is not the size of them but rather that no one had a plan of any note. I will accept the argument that this was an extreme event, but there were no plans at all within organisations such as banks and fund managers to deal with the collapse in asset values they experienced. What response they did have was somewhat akin to an ostrich sticking its head in the sand and squawking "I can’t see you". The only response that regulatory authorities had was to ban short selling which only made matters worse. Once this had occurred I was surprised that these geniuses didn’t go all the way and simply ban selling all together! The interesting thing about trading is that the psychological problems that bedevil traders are universal in that they also affect all individuals involved in complex or stressful decision making. If we return to the example of the bushfires again, Dr Mary Omedie of Latrobe University has done some interesting work in the area of decision making by fire fighters. In her simulations she has found that once fire fighters commit resources to a given fire they are very reluctant to remove these resources to deal with a secondary threat. They are emotionally anchored in their decision and are therefore reluctant to change their strategy. This is precisely the same issue that traders face when things begin to go wrong with a given trade. We are emotionally as well as financially invested so we struggle to alter our strategy. This situation gets worse when events begin to unfold in an entirely unexpected way. Dr Omedei makes the following salient point when looking at decision making among fire fighters - "We’re sort of very much thinkers of the present. We’re hard wired to sort of think things will keep changing the way they’ve been changing up to that point." Consider this quote within the context of trading. Traders make the assumption that tomorrow will be the same as today and therefore any planning that is undertaken reflects this very basic perception. There is no account taken of the fact that not only will tomorrow be different to today but that it may be so different as to be almost unrecognisable. We perceive that change occurs at a constant rate, or at least has a constant theme, and we plan around this constancy. Unfortunately the world, and particularly the trading world, is not like that. Dr Omedei continues - "To put it into more cognitive terms we grossly over estimate our mental capacity. We over estimate the amount of information we can deal with, we over estimate the rate at which we can process information". In other words we are not as smart as we think we are. Complex systems that are undergoing rapid variable change overwhelm us. So the question becomes, if we acknowledge that we suffer from these cognitive drawbacks, what can be done in a trading sense to deal with our shortcomings? I think the following list goes someway to addressing the situation. 1. Leave your ego at home – if you begin to imagine that you are the master of the universe then the universe will show you who is actually boss. You are not as clever as you think you are. 2. Plan not just for trades that go to the moon but also trades that come crashing back to earth. Scroll through the All Ordinaries and imagine what you would have done if you had instruments that suddenly lost a large amount in value. Rehearse how that might feel and what steps you would take to survive. 3. Cultivate the notion of survival as the prime driver of your trading. Remember the market has one very harsh rule – no dough, no play. When all your money is gone, that’s it.- -Chris Tate.