With Dr. Gary Dayton, Trading Psychologist and Author of Trade Mindfully: Achieve Your Optimum Trading Performance with Mindfulness and Cutting Edge Psychology
In his new book, Trade Mindfully: Achieve Your Optimum Trading Performance with Mindfulness and Cutting Edge Psychology, Dr. Dayton presents the two true components to what can make you become a successful trader. Dr. Dayton is an expert on trading psychology and advocates applying the concepts and practice of “mindfulness” to improving trading strategies. Mindfulness, according to Dr. Dayton, goes back more than 2,500 years to the mental techniques used by yogis and Buddhist practitioners to calm and focus their minds on the moment, and he shows us how these strategies can be used by investors to reduce stress and the fear of loss and to control unwanted trading emotions and ‘recency’ effects—to improve objectivity in interpreting trading data and gaining an edge on portfolio performance.
Loss Aversion, Recency Effects, and Other Biases and Distractions
He discusses loss aversion and why losses hurt more than the euphoria of equivalent gains and how this impacts portfolio performance. His techniques are about training the mind for greater attention, better focus, and casting aside distractions and their influence on our trading behavior. The idea is to get over your visceral emotions and to let rational decision-making prevail. He shows us how to ignore data that really is not relevant to our portfolio’s performance, and gets us to dig deeper into questions that are more relevant to our trading goals.
He addresses the ‘recency’ effect, where recent experiences are more heavily weighted in our minds and lead to irrational decisions. For example, three losses in a row lead to greater loss aversion or three profitable trades could lead to irrational exuberance and losing trades. He presents solid research on loss aversion (how losses hurt a lot more than equivalent gains) and how mindful trading puts loss aversion in perspective.
So, listen in to get an edge on your trading strategies. While short-term trading may work for some, these mindfulness techniques can be equally useful for fundamentals-based investing and holding shares for the long term, which is undoubtedly a safer wealth preservation and growth strategy.
Steve Pomeranz: In his new book, Trade Mindfully: Achieve Your Optimum Trading Performance with Mindfulness and Cutting Edge Psychology, Dr. Gary Dayton presents the two crucial components of what he says is the last true edge for making money in today’s markets. While I’m personally not a fan of active trading, there are a lot of investors who practice this difficult and arcane art, so let’s see if we can peer into the mind of the active trader and help them be more successful. Dr. Dayton, welcome to the show.
Gary Dayton: Thanks, Steve. Thanks for having me. It’s a pleasure to be here.
Steve Pomeranz: You use the word “mindful,” “trade mindfully,” and it sounds so new-agey. What does this term mean to the active trader?
Gary Dayton: Yeah, that’s a good comment. It’s a hot topic right now, and rightfully so, because the science on mindfulness is just coming out. We are seeing almost weekly a new research report coming out that is showing us that mindfulness is a pretty powerful mental skill, and it really has special value to investors and traders. Doesn’t matter if you’re a short-term trader, a swing trader, or a long-term position trader. Mindfulness can be very helpful to you and your trading.
Steve Pomeranz: But what is that? What does this word “mindfulness” mean?
Gary Dayton: It’s a mental skill, and it actually comes … You described it as new age, but it’s got a longer history than that. It goes all the way back maybe 2600 years or more, back to the yogis and the Buddhas, the Buddhist practitioners in India and East Asia. Basically, what it means for investors and traders is to be able to operate in the markets with a stable and calm mind. It gives investors and traders several important abilities.
First and foremost, it reduces stress, significantly so, and reduces the fear of loss. Just before we came on, we were talking a little bit about some of the biases that people have in their thinking, and one certainly is loss aversion, where we’re fearful of taking losses, and that causes different kinds of investor actions rather or behavior which are not really helpful.
Steve Pomeranz: Are we talking about meditating? Are we talking about doing yoga? Or are we talking about techniques to apply in the actual act of trading?
Gary Dayton: All of the above, actually. Meditation is fine, sitting and training your mind to watch your breath. It sounds sort of mundane, but basically what you’re doing is training your mind for greater attention, and as you do that, we begin to see things like the market more clearly because our attention is enhanced. We begin to realize through mindfulness that thoughts and feelings that we have, even strong feelings, really are just temporary events with inside of our bodies and within our mind. They tend to come and go on their own. Mindfulness helps keep us present, and so worries about what happened in the past or worries about what might happen in the future start to fade away almost as if they’re a radio playing softly in the background, and they don’t influence our current investments or trades like they can.
Steve Pomeranz: There are things that happen during your trading or happen during the day which may elicit physical reactions from you that are not necessarily conscious, but it’s operating maybe in the primitive part of your brain. I guess the idea is to try to know the difference between those kinds of emotions and try to avoid the mistakes that acting upon those emotions can bring. At least, before we were on air, we talked about this word “heuristics,” which is defined as the taking of mental shortcuts, and we do this to survive as a species. Take us through this idea of mental shortcuts, first on how we use it to survive and then how it affects our ability to invest properly.
Gary Dayton: Okay. Mistakes aren’t always made out of emotional turmoil, but our thinking, in fact, our normal way of thinking, causes mistakes in investing and in trading. We don’t even realize it, which is why I call these mental blind spots. Let’s take an example, and you’re absolutely right, Steve, this is an evolved ability that we have that actually helps us very well in our day-to-day lives. We want to be conservative in our use of our thinking and be efficient, as efficient as we can.
I’ll give you an everyday example, and then I’ll bring it into investing and trading. Let’s say we’re in an unfamiliar town, and we’re driving on a road; we don’t know it. Let’s say it’s six o’clock at night and we’re hungry. We need to find a restaurant, so we see one on the side of the road. We pull into the restaurant parking lot. We see a few cars there. The building looks nice, and we see a couple of people coming out and they seem to be laughing and smiling and having a good time. We say to ourselves, “This must be a good place to eat. Let’s stop here.” Now pause for a moment and just take a look at how we made that decision. We haven’t interviewed the patrons coming out the door. We haven’t gone in and asked the chef for a taste to sample the food. We’ve based it on the appearance of the restaurant, a few cars, what the building looks like, and some people coming out.
Steve Pomeranz: We’ve made some assumptions based upon some basically superficial ideas.
Gary Dayton: Yeah. Actually, what we’ve done is we’ve substituted an easy question and answered it for a harder question.
Steve Pomeranz: Okay.
Gary Dayton: The easy question being, does this restaurant look good? Easy to answer that. Anybody could answer that. The harder question, will this food be to our liking, is a much more involved and more difficult question to ask.
Steve Pomeranz: How does this translate to trading?
Gary Dayton: Let’s take a look at trading, then. A trader sees a bull flag on his chart or her chart. Bull flag is a continuation pattern in an uptrend, and so they say, “Let’s go along.” Mere appearance can be deceptive in this regard because the bull flag could be occurring at the top of a rally or where there’s some significant resistance, and it could actually be the start of selling or distribution, not the continuation of the trend.
Again, it’s our normal decision-making that comes into play here. We’re asking a simple question: Does the chart match the bull-flag pattern? The answer is yes. The harder question, though, is, what’s the likely next move of the market? That’s never asked because that requires much more mental work.
Steve Pomeranz: Very good point. As a matter of fact, one of the reasons I don’t like short-term trading is when I saw the bull flag, and I couldn’t tell whether it was a top or was a continuation of a trend. I went, “You know what? This is not for me.” I started looking at balance sheets and other kinds of things that I could wrap my arms around.
What about this idea of what is called “recency” effect because I know this is very powerful, and any investment advisor or money manager is familiar with this? Tell us what that is.
Gary Dayton: Sure. Recency is a very powerful thinking effect that we have. It’s another one of our biases that, if we’re not aware of it, can get us into pretty good trouble. Let’s say we’ve had three losses in a row and the same investment or trade sets up again. Because the recent experiences are weighted heavily in our mind, we’re less likely to take that trade or that investment. We’re going to say to ourselves, “Gee, I just had three losses, and that hurt. I’m going to pass on this one.”
Now it’s not just for negative things or things that happen bad to us, it’s also for positive things that occur to us. If we’ve just had three outstanding investments in a row, we tend to let our guard down. We tend to say, “Oh, well, you know, let’s just take any old trade that comes up and we’ll make a good trade out of it.”
Steve Pomeranz: Yeah. I recently did a piece on “Good Markets Make for Bad Decisions.” It’s really the same idea, that as you seem to make good investments because the market is going up … Probably has really nothing to do with your talent … You tend to let your guard down and start buying companies that maybe aren’t really the kind of quality you would normally buy. That’s, in a sense, what you’re talking about. Let’s talk about loss aversion. Actually, Dr. Dayton, before we do, let me reintroduce your book. The book is Trade Mindfully: Achieve Your Optimum Trading Performance with Mindfulness and Cutting Edge Psychology. Like I said, even though I don’t subscribe to this method of trading, this is a very, very good book, with lots of good information. Let’s talk about loss aversion and the fact that the pain of loss is so much more powerful than the pleasure of an equal gain.
Gary Dayton: Yeah. Solid research, going back into the 1970s, started by Daniel Kahneman, a Nobel Laureate, psychologist and Nobel Laureate, and his research partner, Amos Tversky, who, unfortunately, died at a young age, they began this research back in the late 1970s. From that point on, we know pretty well that losses loom much larger than gains, and we can quantify it. Research shows that somewhere between two and two and a half times … Losses are two to two and a half times felt psychologically compared to gain. What does that mean? If we have a gain … Let’s say we win $1000.00 on a trade. That feels pretty good. If we have a loss of $1000.00, it doesn’t just feel like we’ve lost $1000.00, but it feels like we’ve lost somewhere between $2000.00 and $2500.00. The magnitude of losses are felt much more significantly than gain.
Steve Pomeranz: How does mindful trading help to deal with these very powerful forces that we as human beings have developed over these many millennia?
Gary Dayton: Let me give you an example using one of the aspects of loss aversion. Because we are averse to loss, we have a tendency to cut winning trades short or winning investments short. Let’s say we get into a long investment and we have a projection. Maybe we get in at $100.00 and we have a projection for $125.00 profit, and, at about $105.00 or $106.00, the market backs up a little bit on us, and we start to get anxious about it. We start to get fearful, and the mind starts going, as our minds will do, and starts saying, “Well, Gary, you better take that trade off, you better get your investment off. You want a book. You can get five points here. I know you got a target of 25, but 5 is better than having a loss.” The mind will go on that and get insistent, in fact, because of this powerful feeling of loss aversion, and so we take the trade off. Now we feel good. We feel relief from that. All the stress has drained out of our body, the muscle tension, the dry mouth, the queasy stomach, all of that, the sleepless nights. All of that goes away. Then what happens? When the market continues in our direction and it goes up to $125.00 a share, we’re standing on the sideline. What does our mind say to us then?
Steve Pomeranz: Regret.
Gary Dayton: Yeah. It’s like my mind, it’s going to be, “Gary, you fool, why did you get out of there?”
Steve Pomeranz: That’s right.
Gary Dayton: Now think about this. Here’s the real question that’s never asked. Which mind was right? Was it the mind telling you to get out of the trade because it feared the loss? Or is it the same mind telling you now you did something wrong and now chastising you for doing exactly what it did?
Steve Pomeranz: Of course, in a sense, it’s based on the outcome because if the stock did continue to go down, you’d feel no regret.
Gary Dayton: Right.
Steve Pomeranz: What is the answer there?
Gary Dayton: The question is it now becomes part of your edge, your investment edge or your trading edge. If you find that most of the time you get out because of fear of loss and the trade does, indeed, go down, well, you’ve got something powerful there. But if you’re like most people, you’ll find that you got out and then most of the time, your investment will go in the direction you originally anticipated. Mindfulness is going to help you deal with that. We can’t get rid of feelings like fear. It’s just not possible. I’ve been involved in the field of psychology for about 20 years, and I’ve never met a single person who could consistently control their emotions or their thought over any given period of time. We can’t take emotions away. It’s just not possible. We can add to them, and what mindfulness does is it gives us distance on our thoughts and even strong emotion, and that’s really valuable.
Steve Pomeranz: You can’t really suppress them. They don’t go away. They just come out in other forms and sometimes aberrant forms, but emotions are still there. You’ve got to find another way to understand them and to deal with them. Is that what you’re saying?
Gary Dayton: Yeah. If we say to ourselves, for example, “I don’t want to feel this fear of loss,” well, it’s almost like giving an instruction to your mind to make sure and go out and check to see if you’re having any semblance of fear of loss. Any little anxiety is going to immediately bring it up into our attention so that we can deal with it. The more we don’t want feelings like fear or fear of loss or other emotions that we don’t like, really the more we’re going to have it.
Steve Pomeranz: The book is Trade Mindfully: Achieve Your Optimum Trading Performance with Mindfulness and Cutting Edge Psychology. The author is Dr. Gary Dayton. You can find this book on Amazon and other major outlets, and also go to the site tradingpsychologyedge.com. Also, Dr. Dayton has some skills that he uses that he does online training with traders to elevate their chart reading and other things. It’s called Deep Practice. Dr. Dayton, thank you so much for spending time with us. Wonderful book, congratulations.
Gary Dayton: Steve, this has been a pleasure. Thank you so much.