Self-control and due diligence - Can traders control their urges?

One of the key characteristics of good traders is self-control and due diligence should explicitly take this quality into account when managers are reviewed. Those who do not possess self-control should not be given money because it is unlikely that the good performance of today will be followed by strong performance tomorrow. Self-control is a key trading skill. The good manager can control investment urges. Bad managers will not be able to show self-control in difficult times and will likely change strategies or behavior.

A review of self-control may seem like a strange area of discussion for due diligence. If a manager is rational, there is no need to discuss self-control because the rational economic man, homo economicus will always be a profit maximizing or optimizing individual who will be able to discount all information quickly, efficiently, and correctly. However, we know that is not the case through all of the work in behavioral finance. Those in  the homo economics school will say that any action the manager takes is rational and profit maximizing because he would not otherwise take it. This tautological approach does not address the real world problem that managers often face - an environment that is uncertain and often vague. Hence, it is relevant to try and measure or discuss the self-control of traders.

Some researchers have modeled the problem of self-control as an principal-agent issue between a far-sighted planner and a myopic doer. The focus was a problem of intertemporal choice. There is a doer within us who wants to always take immediate action or look for immediate gratification while our long-term planning self tries to stay on task and think in terms of longer goals. In this problem the long-term principal has to monitor and set controls on the agent. A similar issue can be described with trading when there is short-sighted reaction against longer-term goals.

There are two key methods or focus areas for imposing self-control, cues and commitments. Self-control tries to eliminate cues that will trigger short-sightedness and use cues to help ensure tasks will get done. For example, if we remove temptation with desserts, we will stay on our healthy eating program. Good self-control takes away those things that will trigger non-maximizing behavior. Good traders are able to block out extraneous information or "noise" and focus on what they believe to be truly important. Due diligence may involve determining what are the cues used or blocked by the manager to stay on task or focus. It could be as simple of following a process or the use of specific information.

Commitment is a form of binding behavior to impose self-control. Following a model is a form of commitment. The use of stops to get out of positions is a form of commitment. Commitments stop bad behavior and forces discipline on a manager. The due diligence process should identify the commitment process for each trader.

If cues and commitment cannot be identified, then it will be hard to argue that there is a process to generate self-control.  Of  course, due diligence can also pass into the personal to determine whether there is self-control in non-investment activities. Simply put, control the urges for bad behavior and loses should be controlled.