This article is a follow on to Jon’s previous article on hot states and cold states.
In a cold state, we can think very rationally. We will have a well thought plan as well as contingency plans to be activated. For example, traders would have a trading plan to follow, and if things go wrong, cut loss.
Let’s imagine the market really went against the trader’s position. He entered into a hot state position, stressing over his paper losses. He was unable to think with a clear mind, lest sticking to his contingency plans. He froze and blew up his account as his losses mounts beyond his margin requirements.
That’s the truth. We overestimate our ability to stay rational in a hot state (I am speaking from experience).
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
Dan Ariely, in his book The Upside of Irrationality, recounted his experiments that too much money at stake lowers performance. In fact, he found that people engaging in cognitive tasks have their performance harmed by excessive monetary rewards more than those who engaged in physical tasks.
This isn’t good news because trading is a cognitive task, and it involves money. Lots of it. If the amount at stake is too large, traders are focusing on the amount instead of their trading plan. This causes underperformance. (I bet some of you are thinking ‘this doesn’t happen to me’. This is precisely a cold state response.)
Not only traders are exposed to this issue, investors who take a longer timeframe are not spared too. Investors are aroused by the bull run in the market and they entered into a hot state. They buy high on greed. Investors are also severely affected when the market corrected and they entered into the hot state again to sell their investments at a lower price than they have bought.
One difference between traders and investors is the frequency of exposure to hot states. The former much more than the latter. The other difference is the leverage involved in trading which amplifies the monetary value of their position, and the worry of blowing up. Focusing on what he is trying to avoid, gets him nearer to it. All these suck up cognitive power from the trader which he should have used it to concentrate on executing his plan that was created during his cold state.
Think of a gymnast competing in Olympics. He would have practised a zillion times to perform the routine in near perfection. The stage is here. If the gymnast is focusing on winning, his performance will likely dip as he tensed and stressed up. If the gymnast forgets about the prize, or his possibility of not getting it, and instead focus on the present, he would have achieved peak performance. The scene from Peaceful Warrior played in my head while I typed this paragraph.
But knowing that hot states affect our performance is just a first step. What can we do to maintain our performance?
The answer was also found in Dan’s book,
“First Knight, a movie that came out in 1995 starring Sean Connery and Richard Gere, demonstrates one extreme way of dealing with the way motivation affects performance.
Richard Gere’s character, Sir Lancelot, is a vagabond expert swordsman who duels to pay the bills. Toward the beginning of the film, he sets up a kind of mini sparring clinic where the villagers pay to test their skills against him while he dispenses witty advice for their improvement. At one point, Lancelot suggests that someone out there must be better than he, and wouldn’t that person love to win the gold pieces he happens to have clinking around in a bag?
Finally, an enormous blond man named Mark challenges him. They fight furiously for a brief time. Then, of course, Lancelot disarms Mark. The latter, confused, asks Lancelot how he managed to disarm him and whether it was a trick. Lancelot smilingly says that that’s how he fights, no trick to it. (Well, there is one mental trick, as we discover later.) When Mark asks Lancelot to teach him, Lancelot pauses for a moment before giving his lesson. He offers Mark three tips: first, to observe the man he’s fighting and learn how he moves and thinks; second, to await the make-or-break moment in the match and go for it then. Up to that point, Mark smiles and nods happily, sure he can learn to do those things. Lancelot’s final tip, however, is a little more difficult to follow. He tells his eager student that he can’t care about living or dying. Mark stares into his face, astonished; Lancelot smiles sadly and walk off into the sunset like a medieval cowboy.
Judging from this advice, it seems that Lancelot fights better than anyone else because he has found a way to bring the stress of the situation to zero. If he doesn’t care whether he lives or dies, nothing rides on his performance. He doesn’t worry about living past the end of the fight, so nothing clouds his mind and affects his abilities – he is pure concentration and skill.”
In case you didn’t catch it. Dan was trying to use this story to tell us that Lancelot was able to achieve peak performance in a hot state because he did not worry about the outcome – whether he lives or dies.
In other words, Dan suggests that we have to use irrationality to defeat irrationality.
It is irrational to focus on an outcome that has not happened and let it affect your present performance. In order to avoid this, we need to be irrational to accept that the worst possible outcome can happen and be indifferent about it. Mind boggling right?
Translate that to trading and investing; it means that to prevent ourselves from focusing so much on our paper losses or gains such that the worry harms our ability to make correct judgments, we have to accept we can lose all our capital. What?!
I experienced this myself. I accept that the entire capital that I have invested in a stock can go to zero. I found that it takes away all the worry I have, even when the market corrects, or even if the stock price drops by half.
I am not asking you to lose all your money or to be careless with money. These are just states of mind that we are talking about.
There are 3 attitudes toward money.
First, a spendthrift will waste money on things he should not be spending on. This is carelessness with money. Unforgivable.
Second, a saver is prudent with his money and he provides well for his family. But he worries about money some times and that hindered things he wanted to do in life.
Third, an altruist, who is not stingy with giving. He has enough and he doesn’t care if he gives until penniless. He creates much more impact to society than the other two. In mandarin it is called 舍得; you have to give (舍) in order to receive (得).
It is the third state that I am talking about. It is without the fear of losing that you get more in the end. As the saying goes, take care of the downside and the upside will take care of itself. You have to relieve the worry and fear of losing. Let go of that investment capital and the emotional attachment will be severed. The counterintuitive will become the reality – you turn into a profitable trader or investor.
PS: I had suffered from poor performance coming out with the article today. I prepared two other articles the day before and worked till 1am but couldn’t get one complete. I guessed I was focusing on creating an impact such that the stress unknowingly consumed my creativity. I went to sleep and this morning woke up with the idea for this article. I completed it in less than 2 hours. Dan was right.