“Goodness of character is measured in loyalty to others; greatness of character is measured in loyalty to principle.”
Brett N. Steenbarger, Ph.D.

What makes the guy next door better than me? What does he know?

Consider the example: They both work in the same company. Have the same six figure salaries. So why is one looking forward to early retirement, while the other is looking forward to the 15th and the 31st?

The individual looking forward to the early retirement understands life is a series of choices. He knows that his decisions alone determine his results. If you only look forward to the pay day of the 15th and the 31st, are you not really getting the result you intended? Otherwise you would do something else right? What is that something else?

Behavioral finance is a starting point to that something else.

The difference between the two coworkers is not income, intelligence, or access to information. It is the framework each one applies to decisions involving money. One has built a system for deploying capital that operates independent of mood, circumstance, and short-term pressure. The other reacts to financial decisions as they arise, driven by immediate needs and intuitive judgments that behavioral finance has shown are systematically unreliable. The same gap exists between discretionary traders who rely on intuition and systematic trend followers who operate from a defined set of rules. The rules are the framework. The framework is the difference.

How Can Behavioral Finance Help Your Trading?

Consider these Q and A’s sourced from http://www.tiff.org:

Q. How can behavioral finance make me a better investor?

A. First, Mark Twain was right: “There’s as much human nature in any of us as there is in all of us, and hence the only safe premise on which our investment behavior can be based is the assumption that our intuitions are likely to mislead us from time to time.” From this, an important corollary follows: To prevent us from acting on wrong intuitions, we need frameworks — literally checklists or worksheets — that compel us to consider factors that, acting on intuition alone, we are likely to miss. Admittedly, some especially gifted investors can do well without such devices, but the rest of us cannot.

TurtleTrader comment: A trend following trading system can be thought of as a checklist.

The checklist framing is precise. A pilot does not rely on memory and intuition before takeoff. They work through a checklist that ensures every critical factor has been addressed regardless of how experienced, confident, or pressed for time they are. A trend following system is the trading equivalent. Before the position is entered, the checklist is complete: the signal has been confirmed, the position size has been calculated relative to current volatility, the stop level is defined, the maximum risk is within bounds. Nothing is left to intuition at the moment of decision. The checklist was built when the mind was clear. It runs every time regardless of mood. For the specific checklist behind the original system, see the TurtleTrader rules.

Q. What’s the most pervasive tendency discovered thus far within behavioral finance?

A. Probably myopic loss aversion, which refers to the empirical fact that investors experience more pain from a dollar lost than they experience pleasure from an equivalent dollar gained. Consequently, most choices involving losses are risk-seeking — i.e., people will gamble on the margin to avoid losing — while most choices involving gains are risk-averse.

Myopic loss aversion is the behavioral foundation of almost every trading mistake documented in the research. It explains why traders hold losing positions too long: cutting the loss makes it permanent and the pain is unbearable, so they gamble on recovery. It explains why traders exit winning positions too early: the gain feels fragile and the fear of giving it back produces risk-averse exit before the trend has run its course. Both behaviors, holding losers and cutting winners, are the direct behavioral expression of loss aversion acting on trading decisions in real time.

Trend following’s mechanical exit rules are a structural solution to both failure modes. The stop loss removes the gamble on recovery by exiting the losing position at a predefined level, before the loss grows into an unmanageable position. The trailing exit removes the premature exit by holding the winning position until the market’s own price action signals the trend is over. Neither decision is made in real time by a trader experiencing loss aversion. Both are made in advance by the rules, which have no emotional state and no preference for how a trade turns out. More on risk management and how position sizing controls the pain of individual losses before they occur.

You may also enjoy this article on investor psychology.

Loyalty to Principle

Steenbarger’s distinction between loyalty to others and loyalty to principle is the trader’s challenge in precise language. Loyalty to others in trading means following consensus, acting on tips, holding a position because a respected analyst still believes in it, or refusing to cut a loss because the original thesis came from someone whose judgment you trust. Loyalty to principle means following the rules regardless of what anyone else thinks, what the news says, or how uncomfortable the current position feels. The trader loyal to principle exits the loser when the stop is hit. The trader loyal to others holds it because they cannot face the social and psychological cost of being wrong in front of people whose opinion they value.

The coworker looking forward to early retirement is loyal to principle. He made a set of decisions about how to deploy capital, built a framework, and followed it even when the alternative, spending more, feeling richer now, offered more immediate gratification. The trend following trader operates on the same foundation. The principle is the system. Loyalty to the system is the practice. The results are what follow over time. For the full story of how that practice was proven in one of the most documented trading experiments in history, see the TurtleTrader story.

Frequently Asked Questions

What is myopic loss aversion and why does it matter for traders?

Myopic loss aversion is the empirical finding that investors feel the pain of a loss approximately twice as intensely as the pleasure of an equivalent gain. This causes two systematic trading errors: holding losing positions too long because cutting them makes the loss permanent and unbearable, and exiting winning positions too early because the fear of giving back a gain outweighs the potential for further profit. Both behaviors are directly addressed by mechanical trend following exit rules.

How is a trend following system like a behavioral finance checklist?

Because it compels consideration of the factors that intuition alone would miss or distort. A checklist prevents a pilot from skipping a critical step under pressure. A trading system prevents a trader from holding a loser too long or cutting a winner too early under emotional pressure. Both devices substitute a pre-built framework for real-time intuition at the moment when intuition is most likely to fail.

What does Mark Twain’s quote mean for investors?

That the safest assumption is that your intuitions will mislead you. Not occasionally, but systematically. Behavioral finance has documented the specific ways those intuitions fail: loss aversion, overconfidence, anchoring, confirmation bias. The investor who assumes their intuition is reliable will eventually be proven wrong. The investor who builds a framework specifically to counteract intuitive failures will perform more consistently over time.

What separates the person looking forward to early retirement from the one waiting for payday?

The framework applied to financial decisions. One has built a system for deploying capital that operates independent of immediate gratification and short-term pressure. The other makes financial decisions reactively based on immediate needs and intuitive judgment. The gap between them compounds over time. The same gap, produced by the same behavioral differences, separates systematic trend followers from discretionary traders over long enough time horizons.

Trend Following Systems
Want to learn more and start trading trend following systems? Start here.