📖[PDF] Trading Psychology 2.0 by Brett N. Steenbarger | Perlego (2024)

Emil's Restaurant

Emil is a chef who purchased a restaurant in a prosperous suburb. The restaurant had not been making money for the past few years despite having a broad menu, a friendly owner, and good standing in the community. The young couples that flocked to the suburb because of its superior public education system, convenient shopping, and low crime rate wanted something other than a traditional, sit-down restaurant. They desired a bit of the city life: a lively venue for eating, drinking, meeting friends, and socializing. The old restaurant was just…too…old…and the owner could not keep pace with shifting diner tastes. So he sold the place to Emil.

Emil spoke with the new area residents to learn more about what they wanted in a restaurant. What he heard was that they wanted “fresh”: fresh food, a fresh look, fresh music. He asked them to name some of their favorite urban hangouts, and then he visited the establishments. What he found was large bar areas with long tables, so that people could mix and mingle easily and share their “small plates.” Few people at those establishments sat down for large entrees and multicourse meals. Rather, it was all about grazing and drinking and mixing with people in an upbeat environment.

Emil recognized that the market had changed. What used to bring in customers no longer was attractive. A growing portion of the dining population desired a social experience, not just a quiet, well-prepared meal. They enjoyed moving around and trying different foods, not sitting and feasting on a single main dish. Creative drinks and lively contemporary sounds were an important part of the experience. The new diners wanted more than the usual background music and traditional beverage selection. They loved upbeat electronic sounds, inventive mixed drinks, craft beers, exotic soft drinks, and a broad selection of unique wines from quality vineyards.

So Emil rebuilt the business. In place of the heavy wooden dining tables and chairs, he purchased modular, colorful seating that could be quickly arranged and rearranged to create a variety of environments, from open bar to sit-down brunch. Gone were the traditional pictures on the walls, replaced by soft, streaming lights that illuminated exotic woods, stone, and glass block. Cutting-edge music videos played on large, hi-def screens, amplified by a high-quality sound system. A fresh website, Twitter feed, and Facebook page alerted diners to the day's upcoming dishes. A photoset of dishes being served was uploaded each day to Instagram and linked to other social media.

Those, however, were not Emil's most radical changes. He decided not to change the old restaurant's menu, but to do away with menus altogether. In place of the traditional fixed menu supplemented with a few “daily specials,” Emil committed to making every dish fresh every day, based on ingredients he could source that morning in local markets. If Emil and staff found a superior catch of fresh fish, excellent cuts of dry-aged beef, and several local fruits and herbs, the evening's dishes featured combinations of those ingredients. Each day, he and his kitchen team created an entirely new menu. The slogan beneath the restaurant logo said it all: “A different restaurant every day.”

Freed from the constraints of a menu, Emil enabled his customers to order from tablets distributed by the wait staff. Now patrons could read detailed descriptions of each dish and its ingredients, enter their orders electronically, and send orders immediately to the kitchen. The tablets were readily available throughout meals, so that diners could order fresh drinks and even share comments about what they liked best and least. Those comments helped subsequent customers make their choices. Diners especially liked reading about suggestions for pairing dishes and beverages. As the comment base grew, the ordering system became a kind of internal social media site, where dining ideas were crowdsourced and regulars developed reputations for their food and drink reviews.

The greatest power of the ordering system was that it created a database for Emil. Over time, he learned what diners liked and didn't like. He discovered that younger males liked different drink/dish combinations than women in their mid-30s. He learned how couples ordered differently from single patrons; he found that the descriptions and pictures of dishes greatly influenced their popularity. Female customers preferred poultry and fish dishes to ones with red meat; older diners looked for quiet tables and several course meals; customers who ordered the most mixed drinks were also the ones who ordered the most specialty coffee beverages. Gradually, the database helped Emil understand which dishes to emphasize and which to eliminate. He created a different restaurant experience on weekend evenings than weekday afternoons: different food, different layout, and different music. Armed with continuous data from customers, he rapidly adapted to shifting tastes.

And the customers? They loved the up-tempo music, the clean modern lines of the décor, and the “cool” ordering app. The website gained traffic; Twitter followers and Facebook friends exploded: There was a buzz about Emil's restaurant. Were there setbacks? Of course. A customer dropped his tablet and shattered the screen. That led to new protective devices for each “menu.” A few inebriated customers wrote inappropriate comments in their reviews, so Emil instituted greater monitoring of entries. Several older customers, befuddled by the newfangled electronic instrument on their table, needed to be coached on how to operate the tablet. That led to simple step-by-step instructions displayed on table tents throughout the restaurant. Each problem led to a fix, and each fix gave Emil an opportunity to show customers he cared.

Best of all, Emil was able to hire a superior kitchen and wait-staff, as people wanted to be part of this cutting-edge venture. He announced sizable bonuses for staff members who generated unique ideas implemented in the restaurant. One waiter suggested that the app could also take people's music requests, so that staff could play diners' favorite tunes during their visits. A junior chef further suggested archiving all the music choices, so that the database included the music selections for customers who completed a profile. Then, when each customer made a dining reservation, his or her favorite tunes were automatically added to the evening's playlist.

What Emil recognized is that adapting to changing markets means being willing to change who you are and what you do. The new restaurant embodied new practices (playing customers' favorite music), but also new processes (electronic ordering informed by crowdsourcing). In redefining dining's social dimensions, Emil created truly fresh experiences for customers and a distinctive “edge” in the marketplace. Thanks to a deep database tracking orders and preferences, he ensured that, in Darwin's terms, he was the “most adaptable to change.”

Emil could only accomplish that, however, by embracing change. “A different restaurant every day” became both a challenge and mission. Staying fresh—never static—was the key to success. Instead of structuring the restaurant the way he wanted, Emil let the customers define the experience. His motto wasn't “If you build it, they will come.” Rather, he figured out what made people come and built his restaurant around that.

The Single Greatest Barrier to Adaptation

By now you have figured out the relevance of Emil's restaurant for trading financial markets. As traders, we have ideas about how to generate returns from markets. Some of those ideas exploit macroeconomic trends or company fundamentals. Others draw their inspiration from technical patterns or carefully tested relationships among predictors and market outcomes. Rarely, however, do market participants develop explicit processes for adapting to changing markets. In that respect, we are like chefs who think that if we keep preparing good dishes, customers will forever line our doors. The failure to adapt to shifting markets manifests itself in sadly tone-deaf spectacles: portfolio managers chasing macroeconomic themes in markets dominated by the effects of positioning and sentiment; momentum traders playing for breakouts in low-volatility, rangebound markets; money managers adding to risk on “diversified” portfolios even as correlations and volatilities ramp higher.

In each of these cases, the result is frustration and potential emotional interference with future decision making. The root cause of the frustration, however, is logical, not psychological: It is the natural consequence of failing to adapt to a changing world. The restaurant owner who sold to Emil was probably frustrated with the business, but that is not why success eluded him. He was a good owner; he did what made diners happy. Unfortunately, he kept doing it long after a new kind of diner had entered the scene.

To be sure, there are traders with discipline problems and poor impulse control. There are also traders who act out unresolved emotional conflicts in markets, with predictably tragic results. But successful money managers do not suddenly morph into emotional basket cases. When we see mature professionals act out of frustration, ready—like the restaurant owner—to give up the business, there's a high likelihood that this is a failure of evolution, not merely a failure of psyche.

So why don't bright, successful professionals adapt? Why don't we, like Emil, embrace change and the stimulating challenges of renewal? Too often, the answer is ego: Once we are attached to a given reality, it becomes difficult to embrace another.

The previous restaurant owner believed in his menu. He was passionate about his cooking and customer service. And that passionate belief killed his business. He became so attached to—so identified with—his business model that he could not construct an alternative. He didn't want to become a different restaurant every day. He wanted customers to flock to the restaurant he believed was best.

Therein lies a considerable dilemma. Entrepreneurs need deep, enduring belief in their businesses to weather the arduous startup process. It is that belief that cements a company culture and attracts talent committed to the firm's mission. That same belief, however, can imprison us. It becomes difficult to embrace change when your very heart and soul are wedded to what you are doing. Ironically, the more committed we are to what we do, the more challenging it becomes to make the changes needed to stay ahead. Think of key innovations in the world of technology—rarely have those sprung from the industry giants. The mainframe computer makers were not those who pioneered the personal computer market; the personal computer makers were not those who popularized tablets and smart phones; social media has arisen more from startups than established software firms. Paradoxically, success can harbor the seeds of its own undoing once innovation becomes status quo.

A dramatic illustration of the difficulties of adapting to change can be found in a research study conducted in 1945 by Karl Duncker. He posed a problem to subjects in the study, showing them a corkboard wall, a box of tacks, a candle, a table, and a book of matches. The challenge was to use these resources to attach the candle to the wall in such a way that it would not drip on the table when lit. Subjects typically tried a variety of solutions, from trying to tack the candle to the wall to lighting the candle and sticking it to the wall with the drying wax. None of these solutions worked; none guaranteed that the lit candle wouldn't drip on the tabletop. The correct solution was to take the tacks out of the box, put the candle in the box, tack the box onto the wall, and then light the candle. People struggled with the problem, Duncker suggested, because of what he called functional fixedness. They were so accustomed to seeing the box as a container for tacks that they failed to envision its use as a candle holder. They were trapped, it seemed, in their mental sets.

Now here's the interesting part: Subjects facing the exact same candle problem but initially shown the tacks outside of their box had a much easier time solving the problem. Once the box was separated from its contents, it was not difficult for the study participants to perceive alternate uses for the box. Instead of seeing it as a container for tacks, they perceived it as an empty box. With a different perceptual frame, subject...