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Why is it that results “produced” through paper trading are discounted relative to those that are actually generated?
For anyone who has managed capital, the reason is obvious. What a paper trading strategy lacks is the emotional impact of losses, gains, regret, and accountability. When real money is at stake, repercussions from a misstep can involve serious consequences, and that affects the decision maker, and her process.
The fact that paper trading returns are discounted, rather than the other way around, implies that it is more difficult to generate returns when dealing with those emotional factors. This begs a few questions that surprisingly are rarely asked. If it is easier to generate returns when emotion is removed, why is so little time and effort spent focused on doing exactly that, and why do so many widely accepted, fundamental tenets of our industry serve to inject emotion into the decision making process, rather than remove it?
When risky decisions involve outcomes that conjure a significant emotional response, they are considered affect-rich. When they don’t, they are categorized as affect-poor. It turns out, when we face decisions that have a greater potential to affect us emotionally, we are more likely to rely on our intuition and other mental shortcuts, resulting in decisions that are more emotionally driven, and less probabilistic. Exactly the opposite of what you want when attempting to improve the odds of a successful decision, including those regarding investments.
According to recent research, the impact is even more perverse than you might imagine. Researchers from Germany and Switzerland have shown that individuals facing a problem with an affect-rich outcome often come to polar opposite conclusions to the very same problem when it is attached to an affect-poor outcome, and vice-versa. In other words, the very same person, with the exact same skill set, analytical tools, views, and expectations, when facing the very same decision, will make very different choices when their emotions take over.
Think about that for a moment. When real money is on the line, we are more likely to make worse decisions. Worse, as compared to our unemotional self. Now, consider some of the things we do on a regular basis that actually inject emotion into the decision making process of those who are managing our money. Take, for instance, the common practice of requiring a CIO to invest a substantial proportion of their personal wealth in their fund. The intention is to ensure that their goals and those of the investor are aligned. These emotional investments decisions do not have the same intensity when executing a paper trading strategy.
According to the research, if the investor’s goal is to help the CIO make decisions that are more probabilistic and less emotional, thereby improving the odds of better returns relative to risk taken, they’d be best served by not forcing the CIO to invest a proportion of his wealth that is likely to turn an affect-poor decision into an affect-rich one.