Animal spirits in the market.


Recently, the words ‘animal spirits’ have become popular ever since it got used by govt officials in connection with the economy and industry etc. Thinking about it, I realised that ‘animal’ spirits applies even more to trading and investing! Here is how.

Jake Bernstein in his book The Compleat Day trader compares the process of waiting for a good trade to show up to the way a jungle cat waits for its prey in the savannah grass. He describes the qualities of the cat and shows how traders need to develop those kinds of qualities to become successful in the market.

Then there are quizzes that ask you to think of an animal spirits when you think of the market or trading/investing. The animal you think of is supposed to represent your state of mind, your psychology towards the markets. It is postulated that the qualities of the animal that you thought of are the ways you perceive the market to be and hence your behavioural patterns will be in response to how you see the market or its equivalent, the animal spirits.

These are interesting but the most interesting aspect was an article written by Richard Bookstaber, titled “Risk Management in Complex Organizations”. The article deals with risk and how to deal with it. In this article, Bookstaber writes,

The best measure of adaptation to unanticipated risks in the biological setting is the length of time a species has survived. A species that has survived for hundreds of millions of years can be considered, de facto, to have a better strategy for dealing with unanticipated risks than one that has survived for a short time. In contrast, a species that is prolific and successful during a short time period but then dies out after an unanticipated event may be thought of as having a good mechanism for coping with the known risks of one environment but not for dealing with unforeseeable changes.

I thought this passage was particularly applicable to us as players of the market. How so? Think of this- the minute we take a position in the market – as a trade or an investment- we start on a road of risk. As long as the position is open, the risk is open. Much of investment and trading thesis- particularly the latter- is about how to deal with the risk aspect and how to control it, how to minimise it etc. After all, reward is what the market gives us and we don’t control that at any point of time. The only thing that we can control, ergo, is risk. Now, as Bookstaber describes, as a market player, we have to deal with expected or known risk as well as unknown or unforeseeable risk. And we have to survive them.

Going back to Bookstaber’s words, let’s think of what species has survived the longest? It is the cockroach. This is one pest that has survived millions of years and therefore holds out as an example of dealing well with expected as well as unexpected risk. Hence it would be logical to conclude that whatever the cockroach does to deal with risk (of both kinds) should be worth copying and doing!

So what did the cockroach do to succeed? It is quite simple really- it always ran away from any kind of risk. You have to realise that the lowly cockroach has both a sense of smell and sight and has these antennae out as well for sensing the environment. We humans have 5 of these sense organs too and what these do is to produce various kinds of “clues “that the mind processes in order to arrive at a suitable risk management system. We then act upon this system. However, the species that have survived, have learnt to completely ignore these olfactory or visual or sensation stimuli and use their triggers to flee. They never fight. So, the ability to ignore what seems like valuable information is clearly visible in the species that have survived over the millennia.
Now take the case of humans. They believe that this vital information (which they get from their senses) is to be processed and used intelligently. We therefore rationalise and justify situations of risk and then decide what action is to be taken. The underlying assumption here is that the brain is processing these correctly! The human brain is unchanged since man first walked on this earth and has gone thru millions of years of training of the ‘fight or flight’ response. Over time, advances have made us choose the ‘fight’ response more than the ‘flight’ response. That is mainly because we have become more in command of the environment, we have built better tools and have created structures that can deal with threats better.

However, the market is a different environment where there is no structure and there is certainly no ‘control’ over the environment. We may have some tools (fundamentals, technical, algos, and technology) but those tools demand a deeper understanding of the environment. Animal instincts of adapting to their current conditions are quite remarkable but the same is not exactly true about humans. For example, “animals placed for the first time in a laboratory setting often show a less fine-tuned response to stimuli and follow a less discriminating diet than they do in the wild. This behaviour, although not totally responsive to the current environment, allows survivability if the nature of the food source unexpectedly changes”(Bookstaber).

Every trader hates the word “stoploss” and investors consider it an evil! But think of it. Your FA and TA or you Algos would take into account all optimal risk-management system of known factors. They cannot handle the unforeseeable factors! Only the stoploss does that! It is like saying that I have seen all these factors and these are my response to them but beyond these factors I have no answer! The factors that go into our model (fundamental, technical or algo) are all therefore finer decision rules- one that values important information. But remember the cockroach? They choose to IGNORE seemingly valuable information. This is what a Stoploss does! It says that there are new elements now that are not part of the code or the system or the method and there are no ready solutions or answers available for this. Therefore the best course of action is to Flee.

Realise that the valuable information that created the trade in the first place is still available. Only, there is something new that has emerged which is not part of the system. To deal with this, we now need a coarse decision rule- one that ignores valuable information. And that is the Stoploss.

As an example, I saw recently that one of the FIIs sold one small cap item at a price of Rs.0.25 and 0.21 on successive days (and large quantity). Obviously, their finer decision making systems did not kick in until this price! To put it into perspective, this stock was trading at Rs.6 levels about a year ago and Rs 20 about 5 years ago. It is clear that optimal arguments delayed the exit from the stock even as it continued to drift lower across the months and years. And this was one the top FII names so one can presume that they had all the necessary information to create suitable models based on FA/TA/Algo.

The coarse response, although suboptimal for any one environment, is more than satisfactory for a wide range of unforeseeable environments. Bookstaber puts it more succinctly, “Precision and focus in addressing the known comes at the cost of reduced ability to address the unknown.” Understand that with our knowledge of FA/TA/Algo we are practicing ‘precision and focus’. The FII referred to above example were practicing precision and focus. The coarser Stoploss is the only weapon we have to address the unknown or the unforeseeable!! Nassim Taleb, the great thinker on markets puts this wonderfully: mistaking the unknown for the non-existent. Our conviction on known factors makes us believe that factors contrary to what we know are non existent. The truth is more that they are unknown.

Strategies predicated on a coarse decision making approach like Stoploss may look unsophisticated to many but they make the implementation of strategies over long term more robust and adaptable, leading to greater odds of survivability. The whole point of investing and trading is to be able to stay in the game long enough to make the odds work in favour of you. Imagine if Warren Buffet had not lived to his current age of 89 (his birthday was last week!), would he have seen his fund grow the way it did? Value investing, so popular recently, is all about longevity. And longevity demands that we survive!

In sum therefore, the best animal spirits  to choose to be, is to be like a cockroach in the markets. When you see or smell or sense some trouble, take flight! Don’t rationalise, don’t justify, and don’t procrastinate action for any reason. Just run! If this was good enough for the cockroach to survive millions of years, it ought to be good enough for us to get thru one life time!!

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