What Allocators Can Learn from Paper Traders by Stephen Duneier
Why is it that results “produced” through paper trading, meaning the trades aren’t actually executed, are discounted relative to those that are actually generated? If you think about it, in both cases research is done, views are formed, expectations are set, instruments are selected, entry levels are determined and decisions are made regarding trade exit. Doesn’t that cover what almost every institutional investor spends just about every moment focused on?
Of course, for anyone who has actually managed capital, the difference is obvious. What the paper trader’s experience lacks is the emotional impact of losses, gains, regret, and accountability. When real money is at stake, repercussions from a misstep can involve serious consequences, and that affects the decision making process. That is what distinguishes the results generated through paper trading versus actual investment management.
The fact that paper trading returns are discounted, rather than the other way around, implies that it is more difficult to generate returns when dealing with those emotional factors. I’d be hard pressed to find anyone who disagrees with anything I’ve said so far, which begs a few questions that surprisingly are rarely asked. If it is easier to generate returns when emotion is removed, why is so little time and effort spent focused on doing exactly that, and why do so many widely accepted, fundamental tenets of this industry serve to inject emotion into the decision making process, rather than remove it?
What we are talking about here are decisions made with “affect-rich” outcomes versus those made with “affect-poor” outcomes. When risky decisions involve outcomes that can conjure considerable emotional reactions, they are considered affect-rich. When they don’t, they are categorized as affect-poor. It turns out, when we face decisions that have a greater potential to affect us emotionally, particularly those invoking negative affect, we more often rely on our intuition and other mental shortcuts when considering our options, while disregarding probabilities. In other words, our decisions become more emotionally driven and less probabilistic in nature. Exactly the opposite of what you want when attempting to improve the odds of a successful decision, including trading decisions.
While dozens of studies dating back to the 1990’s have focused on and proven this case, one conducted just last year took it one step further. For the first time, researchers showed the existence of systematic preference reversals between affect-rich and affect-poor choices within individuals. In other words, they showed that individuals who faced a problem with an affect-rich outcome would come to the polar opposite conclusion to the very same problem when it was later attached to an affect-poor outcome, and vice-versa. This study, conducted in Germany and Switzerland, proved exactly what we’ve all suspected. There is a difference between managing a paper portfolio and managing a real one. These researchers proved that even the very same person, with the very same skill set, analytical tools, views, and expectations, when facing the very same decision, will make the opposite choices when emotions take over.
Think about that for a moment. When real money is on the line, we are more likely to make worse decisions, and we know it! Now, think about some of the things we do on a regular basis that actually inject emotion into the decision making process of those who are managing our money. Take, for instance, the common practice of requiring a CIO and other hedge fund partners to invest a substantial proportion of their personal wealth in their fund. What is the rationale for such a requirement? To ensure that their goals and those of the investor are aligned. Well, if the investor’s goal is for the leaders of that hedge fund to make decisions that are more probabilistic in nature, and less emotionally driven, thereby improving the odds of better returns relative to risk taken, the best way to align that goal with that of the manager is to not force them to invest a proportion of their wealth that is likely to turn an affect-poor decision into an affect-rich one. Ironically, that is exactly what the investors are attempting to do, and precisely what they are accomplishing.
When I make this argument, particularly to asset allocators, I get more than a little pushback. Some will argue that it doesn’t affect the managers, that they don’t become more risk averse, which, if you think about it, is an odd argument to make. After all, isn’t that precisely the intention, to keep the manager from behaving like a cowboy with your money? So, if you don’t believe it actually makes the manager more risk averse, what exactly does it mean to be “aligned”? Truth be told, research shows that when you convert decisions from affect-poor into affect-rich ones, you don’t simply make choices more risk averse. As I discussed in Seeds Edition 15-34, there are times when affect-rich decisions will have the opposite affect. The only true constant is that the decisions lack the kind of objectivity and probabilistic foundation you want from someone managing your money
More examples of this type of mistake to be detailed in future editions of Seeds.
"An hour with Steve doesn't just help you find the next great trade. It can change how you think."
Global Macro Portfolio Manager New York, NY Hedge Fund AuM $10 Billion
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis in the College of Engineering, as well as Behavioral Investing, at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 60,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.
"Duneier takes your mind on a journey. You'll end up feeling you've done a lot of analysis in a short space of time."
Emerging Markets Portfolio Manager London, England $2.3 Billion AuM