How to Stop Turning Winners Into Losers by Stephen Duneier
Published March 10, 2016
Two weeks before the most recent Bank of Japan meeting, a client, let’s call him Max, purchased a dollar call spread in the US Dollar (USD) versus Japanese Yen (JPY). He risked 25 basis points (0.25%) of his assets under management (AuM) based on his view that the BoJ would cut interest rates. The BoJ action slightly exceeded the expectations he stated ahead of time in his trade write-up. The market immediately reacted by buying USD and selling JPY, pushing it from 118.50 to a high of 121.65 (+2.65%) within a matter of hours (see chart).
Max’s call spread was showing a profit of 1.8% of AuM with less than 24 hours to go before expiration. The options’ expiration is significant, because it sets a line in the sand for the idea, and its expression. What Max was effectively saying by structuring his trade with that expiration date is that whatever the BoJ does, the impact is likely to be quick and powerful, with 123.00 (the call strike he was short) representing the upper edge of his expectations. He was proven right.
At that moment, the call spread had a delta of 80. In other words, say the call spread was on $100 million per strike, then the p&l on the position was behaving similar to that of an outright cash position of $80 million. With the expiration looming near, Max decided to unwind the call spread and convert it into that cash equivalent. He set the stop/loss “just below where spot was when the announcement came out.” Within a matter of days, the stop was hit and the trade was over. Max had turned a 1.8% winner into a 0.3% gain. The questions we aim to answer in this edition of Seeds are, what mistake did he make, what can cognitive science tells us about why so many of us regularly make the same mistake, and how can we use decision architecture to help us avoid it going forward?
First, let’s define the mistake. Max followed the process beautifully, including thoughtful research and analysis regarding policy expectations and the resulting price action it would likely trigger, as well as the development of an appropriate strategy for expressing that specific view. He did a proper trade write-up complete with rationale, expectations, pre-mortem and reassessment triggers, and when one was triggered, he executed according to the script. In other words, there wasn’t a single mistake in the trade which he named, “JPY14”. He even recognized that the cash position was a new trade, separate and distinct from JPY14.
However, when a new trade is established, it isn’t enough to simply acknowledge it as such. A new trade write-up needs to be written, complete with its own unique rationale, pre-mortem, supporting evidence and reassessment triggers. In this case, it wasn’t done. Why? Max says he was busy with other things and since it was effectively a continuation of an idea he’d already written up, it wasn’t a priority. That was the mistake. Although he recognized this should be considered a new trade, separate and distinct from JPY14, he clearly hadn’t mentally processed it as such.
Had he followed the prescribed protocol, one specifically designed to help nudge him toward better decisions, he would have created a new trade write-up, thereby forcing him to mentally process it. He would have expressly noted the capital at risk (max downside) for the trade as 150 basis points. A six fold jump from that which he thought appropriate for JPY14. While you might argue, as he did (briefly), that given the fact that the BoJ decision was now known, JPY15 involved less uncertainty, and therefore should be sized accordingly, I disagree for two reasons. First, the jump in spot reflected the new policy and therefore shifted spot to its new reference point. Where spot would move in relation to that new reference point involved a different set of factors, each of which engendered their own uncertainty. Secondly, even if you take issue with my first point, the question is, was he now six times more certain about the future of USD/JPY, as his relative position size implied? It’s possible, but highly unlikely. Instead, the more likely explanation for the increased exposure was related to the profitability of JPY14 (1.5% vs 1.8%) and the original risk relative to the protected profit (25bps vs 30bps). In other words, in his mind, Max was playing with house money, and research tells us, we are far less risk averse with house money than we are with “real” money. Which leads us to the science behind this mistake.
The Science: Hedonic Framing
Back in 1998, Read, Lowenstein and Rabin wrote about a concept they called choice bracketing to explain why it is that decisions are often made and assessed as a group, rather than one at a time. What is most interesting is that the brackets should theoretically and mathematically have absolutely no effect. In other words, if you consider the value function for outcomes x and y, it should look like this: v(x+y) = v(x) + v(y). Yet their research showed that it wasn’t typically the case. Due to our very human aversion to loss, it often means that v(x+y) ≠ v(x) + v(y), and vice versa.
Consider, for example, how you would feel about winning a single lottery of $75 versus winning one lottery for $50 and a second one immediately after for $25. According to research done by Richard Thaler, 64% say the two-time winner is happier (read: experiences greater utility). Think about this for a moment. The outcome is exactly the same. In both cases you wind up with $75, yet because of the way the winnings are bracketed you have the following: v($75) < v($50 + $25). In the pursuit of happiness, our actions can defy the laws of logic. The question is, does it matter? The answer is a resounding, “Yes!” Thaler coined the term hedonic framing for the phenomenon and devised a set of principles to help us predict people’s behavior given what we know. Keep in mind, Thaler isn’t condoning the behavior, he is merely attempting to model it. In doing so, we stand a better chance of identifying when we are likely to act irrationally, and that in turn can help us take action to defend against our own natural instincts. According to Thaler, the principles we follow for maximizing utility when we evaluate joint outcomes, which assume the Prospect Theory value function (see graph), are as follows:
Segregate Gains: (because the gain function is concave).
Integrate Losses: (because the loss function is convex).
Integrate Smaller Losses with Larger Gains: (to offset loss aversion).
Segregate Small Gains (silver linings) from Larger Losses: (because the gain function is steepest at the origin, the utility of a small gain can exceed the utility of slightly reducing a large loss).
The Science: Mental Accounting
A few weeks back, one of my graduate students submitted a decision log in which she described how a friend had purchased two tickets to a Beyonce concert for $900 each. When the person she was due to attend with backed out, she faced a decision. Should she go alone and sell the other ticket, offer the other ticket to the young daughter of a friend who had done her a favor recently, or sell both tickets online for the prevailing price of $5,000 per ticket?
Her friend saw the first option like this. She paid $1,800 for the pair of tickets - $5,000 she would receive from the sale = She would effectively have been be paid $3,200 to attend the show, and that made her very happy (read: high utility). According to copious studies on the subject, that’s how most people would analyze the decision, but it’s dead wrong. The reason, is that money is fungible. If she can exchange her ticket for $5,000, then that ticket is equivalent to $5,000. It may not look like $5,000 cash looks, but it is exactly the same. Let’s look at her change in wealth after each of the following scenarios.
She buys two tickets and sells one: +$3,200
She buys two tickets and gives one to friend’s daughter: -$1,800
She buys two tickets and sells both: +$8,200
This way of framing the decision, shows how the ticket holder viewed it. Essentially, her reference point was her initial wealth and so attending the concert alone was viewed as a gain. However, if the problem were reframed using the the maximum return as the reference point, it would look like this:
She buys two tickets and sells one: -$5,000
She buys two tickets and gives one to friend’s daughter: -$10,000
She buys two tickets and sells both: +$0
Due to our natural aversion to losses, it’s very likely my student’s friend would have come to a very different decision had she framed the problem in this way. She also would have seen just how much she was “paying” her friend for the favor. Of course, we haven’t considered the utility (read: happiness) gained by attending the concert, (a) alone, (b) with a friend or (c) with the friend’s daughter, but the point of this exercise is to show that it matters how the options are framed. In other words, where the parenthesis are placed may not affect the math, but it certainly affects the behavior, and that in turn, affects the outcome. As it relates to Max, it matters whether he tagged the JPY cash position as a unique trade, separate and distinct from JPY14. While it’s true that (1.8% - 1.5%) = (1.8%) - (1.5%), the decision making along the way is different.
Decision Architecture: Avoiding the Mistake
There are three things that stand between the way we make decisions and the way we should make them:
Anyone reading this has the ability to make proper decisions. We tend to falter when it comes to bias and motivation. Unfortunately, it requires hard work to overcome bias and avoid its corrosive effects, even if we do recognize it. Unless we make the direct connection between the bias and our performance, it’s unlikely we will muster up the motivation necessary to avoid its deleterious effects.
Over the time we have been working together, Max has made great strides in understanding how his decisions are affected by cognitive bias. Just as importantly, he has made a tremendous effort to incorporate the tools devised to help him avoid it, into his daily process. In fact, I consider him to be a model client, exhibiting the kind of curiosity, introspection and motivation required to improve.
In the case of the episode discussed above, several processes have been put in place to help him bracket his decisions in order to better analyze his decisions and reach optimal conclusions more often. The detailed trade write-up including all the requisite components is one. Giving trades distinct names in order to isolate the specific, unique objectives of the structure is another. Calculating and writing down the Capital at Risk (CaR) in combination with writing a pre-mortem is designed to make the experience of the potential loss more salient prior to establishing the risk. This results in more appropriate position sizing and allows the decision maker to be better prepared for that eventuality should it occur down the road. By doing so, it reduces the emotional impact in the future, thereby reducing the likelihood that the affect heuristic will lead to a flawed decision at some point over the life of the trade. In the end though, this one slipped through the cracks. As his decision architect, I must develop additional safeguards that improve the odds that he will implement the process as prescribed, next time. What makes it so challenging for many portfolio managers, is that they are essentially left to their own devices as far as process goes. They don’t have to turn in time sheets, or fill out a requisition form explaining why they need capital for a new project, as it is for most line managers in other industries. That gives PM’s the freedom to be sloppy and undisciplined. The next step is to create a fictitious version of that external accountability for Max, but it must at least carry the perception of teeth.
"While everyone else is scrambling to answer who, what, where and when, Duneier is focused on explaining the 'why'."
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.
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.
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.
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.
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 50,000 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.
Learn how Bija's proven, proprietary approach to decision making helps the world's top institutional investors generate better results.