Brett Steenbarger: The right psychology for successful investing

It takes tremendous focus for a blind man to climb Mount Everest, a swimmer to take on the English Channel or a speed demon to race an automobile at 400 miles per hour at the Bonneville Salt Flats outside of Salt Lake City. But Brett Steenbarger, a clinical associate professor of psychiatry and behavioral sciences at SUNY Upstate Medical University in Syracuse, N.Y., says that when it comes to performance psychology, nothing may require as much focus and perseverance as investing.

I recently sat down with Steenbarger, who specializes in "brief therapy" - short-term approaches to changing emotional patterns and patterns of thinking and behaving. Steenbarger, who has also been a financial markets trader since the late 1970s, has applied brief therapy to trading and in 2003, published his first trading book, The Psychology of Trading. The book led to a relationship with a Chicago trading firm, Kingstree Trading, and in 2004, Steenbarger started full-time work as a trading coach. Since then, he has started the TraderFeed blog, which has grown into the largest trading and market psychology site on the Web, and he has written another book about performance development among traders Enhancing Trader Development. He also published a self-help guide for traders called The Daily Trading Coach. Steenbarger's aim? To help traders to help themselves with short-term, practical techniques based on sound research in psychology and psychiatry.

DailyFinance: How do you decide where to make your trades?
Steenbarger: I'm mostly a short-term, intraday trader of the stock indexes. I have detailed some of my trading on my blog; most of it focuses on riding short-term sentiment patterns in the market. Specifically, I focus on how volume is distributed during the day to gauge the buying and selling leanings of large, institutional traders. They are the ones that move the market, and my goal is to ride their coattails. I find Market Profile theory to be helpful in conceptualizing trades, and I focus my efforts on a limited number of breakout, reversal, and continuation patterns.

What emerging market trends do you see in the stock market?
We continue to see a dominance of computerized, algorithmic trade in the markets, which affects how markets move. The majority of stock market volume is attributable to program-related trading. It is vitally important that traders be able to track the behavior of these programs. We're also seeing more market movement (short-term trends) begin in Asia and Europe rather than the U.S. Globalization is here to stay, and many intermarket themes followed by large, institutional traders focus on emerging markets and their growth.

How does a trader's short term approach to changing emotional situations affect his success as a trader?
Traders need to be able to sustain focused concentration both to respond accurately to market movement and to access the knowledge and skills they have acquired. If traders become unduly fearful, frustrated, or euphoric, they tend to make impulsive decisions based upon superficial criteria. This can be particularly dangerous if traders lose money, become highly emotional over their losses, and then continue trading in a "revenge" mode. The trader who can disengage from markets temporarily, restore emotional equilibrium, and renew concentration is most likely to learn from adverse market events and not spiral into bad trades and outsize losses.

What are key attributes that make successful traders?

I strongly believe that trading is a performance discipline, not unlike sports or the arts. That means that success is a function of skill development and sustained learning. Successful traders excel at pattern recognition, and only an immersion in markets over an extended time enables traders to internalize patterns and act upon them quickly.

Successful traders must also possess a reasonable degree of risk tolerance and an unusual degree of emotional resilience. Even the best traders go through losing periods. It takes a strong individual to persist in the face of risk, uncertainty, and frequent setbacks.

So traders need to be Cool Hand Lukes?
Well, many successful traders are quite competitive and emotional, so I wouldn't necessarily call them Cool Hand Lukes. But they do have the ability to channel their emotions in constructive ways, so as to not lose their focus on markets. As a general rule, traders-while they are trading-should be focused on markets, not on themselves and their profits/losses for the day or week. As soon as attention becomes self-focused, it is diverted from the reading of market patterns. It helps to be a Cool Hand Luke, but many successful traders talk out or vent their feelings and then stay market focused.

Do successful traders respond from a different part of the brain than unsuccessful traders?

Research in cognitive neuroscience tells us that, when we are calm and focused, we are most likely to be activating our brain's prefrontal cortex, which has been called the "executive center" of the brain. It is these frontal regions that are most active when we are reasoning, planning, and making decisions. During times of stress, regional cerebral blood flows tend to move away from these frontal areas and toward motor regions, to help us with our "flight or fight" responses to danger. As a result, it's precisely at those stressful times in markets that we're most likely to be challenged to stay calm, focused, and centered in our executive functions. Rather, under stress, we tend to act out our fight or flight in markets, often making hasty and ill-considered decisions. Successful traders learn to normalize losses and uncertainties in markets, so that they stay more continuously grounded in those executive functions.

How must traders deal with financial fear, and how, psychologically, can they best deal with this?

I strongly believe that the best response to fear is proper risk management. If traders know in advance how much they can lose in a trade or in their portfolio, they can prepare for that possibility mentally and emotionally, so that they don't respond to the loss as a catastrophe. Ironically, it's by embracing uncertainty and planning for inevitable losses that we normalize them emotionally and overcome fear of them.

Since the recession started, have there been more traders seeking therapy?
Yes, I would say the recent economic challenges have created heightened performance pressures for traders and portfolio managers. It used to be that people feared losing their jobs; now they fear losing their careers, simply because fewer firms are hiring. Among independent, individual traders and investors, we've seen heightened stress due to losses in the stock, bond, and housing markets. Therapists report more business since the markets collapsed, and I think economic uncertainty is a big reason why.

What important lessons would you teach the average investor/trader? What are some common mistakes?
The most common mistake I see traders making is putting money at risk in markets before they have advanced sufficiently in their learning curves. I'm a firm advocate of simulated trading as a learning tool: immersing yourself in market patterns *before* you put capital at risk. Many traders think that trading looks easy and they jump right into the water with market pros. This is a major reason why, by some research estimates, over 80 percent of all traders eventually lose their capital. Success at trading comes no more easily than success at golf, acting, or chess. Many are called, few are chosen when it comes to making a living from such performance activity.

Are you partial to trading in any specific industry/country?
I trade primarily the U.S. indexes, such as the S&P 500 Index, mainly because I've developed indicators of market momentum and strength that work well in that market. I am more of a specialist than a generalist; I don't try to trade all asset classes or markets. I don't feel that I have a performance edge in most of them.

Where do you think the stock market is headed?
I believe we're in a bull market that is situated within a longer-term, secular bear market. I believe that secular bear market began in 2000 and won't end until the middle or end of the coming decade. That would make the current period not unlike 1929-1949 and 1966-1982. Typically we see years of bottoming in a secular bear market before a new, secular bull market gets under way. My hope is that the current market strength is beginning that bottoming process for us.

What changes do you make to adjust to these market conditions?
The changes I've made are more as an investor than as a trader. My wife and I have kept our retirement savings in relatively safe vehicles, laddering yield and focusing more on safety than large annual returns. That has kept us making money during the last 10 years of negative stock market returns. My goal is to keep my capital safe until we see signs of a bottom in the secular bear market. Those lows offer generational opportunities for patient investors.

Is there any one you look up to in the finance industry?
I greatly admire many of the traders and portfolio managers I work with. They have unusual skills and talents, and they are inspiring in their dedication and work ethic. It is an honor to work with true professionals.

What do you do when your are not working?
I listen to music, enjoy family time, and travel. With five children and six grandchildren, there's always somewhere to travel and someone to visit! Music is a major source of inspiration for me. I enjoy club/dance music, as well as heavier goth and metal genres. Investigating markets is not work for me; I love to read about and research markets. I don't think I could sustain the pace of my work--the writing, work with traders, blogging, etc.--if it really felt like work!
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