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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.

      Key Takeaway

      Emotional disruptions of trading provide information, often signaling the need to adapt to changing markets.

      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, subjects were no longer functionally fixed and could shift their mental set and solve the seemingly unsolvable.

      In our story of Emil the chef, it's clear that he succeeded, not by improving the old restaurant, but by shifting his mental set and redefining the concept of restaurant. The functionally fixed previous owner might have tried a host of menu and décor changes to no avail. As long as he stuck with the old definition of restaurant, he was bound to thwart the desires of the new generation of diners.

      Emotional fixedness fuels functional fixedness. When we identify with a way of trading or a kind of analysis, we not only can't perceive alternatives: We typically don't want to see them. Many years ago, I spoke with an equity long/short money manager who was struggling with performance. He viewed himself as a master stock picker based on his ability to identify value that was underpriced by the market. This value orientation made him a contrarian: He liked good companies that were unloved by the Street. The problem was that unloved companies often became more unloved before the market awarded them the expected premium. The stock that was a great buy 20 percent off its highs became a burden to the portfolio once it was 35 percent below its peak. That led to agonizing decisions about selling good companies at bargain prices versus holding losers and risking poor performance and investor redemptions.

      I

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