There is a lot of information available on the effects and problems of cognitive biases and the big impact they have on trading decisions and success. There is, however, very little credible information about how to train yourself to manage them.
To trade successfully we first and foremost need good information. I estimate that about 80% of the trading information that you come across on the internet is either misleading, irrelevant or simply wrong. There is no real secret about what works and what doesn’t, but for a beginner, finding their way unaccompanied through this minefield of misinformation can be quite a challenge.
Another problem is that once you have learnt a technique or trading method, you will become favourably disposed to it even if it doesn’t work. This is just one of the many effects of the phenomena known as cognitive biases.
We often hear the advice that we should not follow the crowd with our trading. I would suggest that as long as your trading decisions are dominated by cognitive biases you are the crowd. It doesn’t matter whether we are talking about Forex markets or fish markets. The skilled and experienced operator in any free market will always, on average, buy lower and sell higher than the crowd. That is how markets work and that is how skilled market operators make their money.
The advice commonly offered for managing cognitive biases is to avoid trading emotionally or to just use will power to overcome their influence.
My view is that this advice barely touches the surface of dealing with cognitive biases which are far more powerful and compelling than many people give them credit for.
You can’t just get rid of them. They are hard wired into our brains as part of the evolutionary process. In many situations they serve us well. For other activities like trading they don’t. We need to learn ways to deal with these innate cognitive biases. To do this we need to build new neurological structures in our brains. Structures that are capable of better managing the myriad of trading situations that we encounter.
Most of the information about overcoming cognitive biases comes from academic research. This information can be difficult for traders to access and the net results are anything but convincing. A significant amount of this research suggests that it is impossible to alter the influence of these biases through any form of training. Experienced successful traders know that it is possible; although only a very small percentage manage to achieve this. Often at a loss to understand how they accomplished it. All they know is that one day the “light” just went on and they “got it”.
Cognitive biases don’t only affect traders. There seems to be increasing evidence that they are either the cause of, or at least a significant factor, in faulty decision making in many fields including life critical areas such as medicine.
What follows is a description of the training method that I personally use for trading. It has slowly evolved over many years.
You first need to understand, at an intellectual level, what cognitive biases are and the effect that they have on your trading.
The definitive text book on this subject is – Thinking Fast and Slow by Daniel Kahneman. If you can’t be bothered reading this quite substantial, but easy enough to understand book, there are plenty of summaries on line but be careful of your sources. Many people have added their own interpretations and got it wrong.
Pre trading preparation
This preparation process is done at the start of each trading session. For me this is a daily practice.
1. Five minute mindfulness exercise – I listen to an mp3 audio file using the Windows media player on my PC. I close my eyes, listen to the audio and focus on my breathing for 5 minutes. This audio file is readily available on the internet or from a number of sites as a YouTube video. Google Mindfullness Bell – 5 Minute Mindfulness Mediation.
2. Brain Workshop –10 minutes a day – this is a free, open source mind training game. There is some evidence that these sorts of activities improve the functioning of the prefrontal cortex (PFC), often referred to as the executive function. The PFC is a critical part of our brain’s decision making process. It is often underdeveloped and underutilised. You can download MSWindows. Mac OS and Linux versions from http://brainworkshop.sourceforge.net/
I follow this 15 minute preparation stage with my daily market research. On some days, after looking at the market, I may decide not to take any trades. My trades typically have a duration of 8 -12 hours, but that is a personal choice that suits my interests and life style.
Journal all trades
I look for retrospective evidence of cognitive biases by keeping a written record of every trade. I would suggest a good place to start is looking at cases where you have failed to cut loses in a timely manner and/or failed to let profits run. I would advise not beating yourself up over these mistakes. I believe it is best to simply observe them and record them by writing them in your journal.
We all rationalise far more than we realise or acknowledge. We need to become consciously aware of this process in regards to trading decisions. Again, don’t beat yourself. Just observe and record your observations in your journal.
Trade Short Term – Think Long Term
An important part of any learning process is feedback. We learn mostly by observing our mistakes and making adjustments until we get it right. There is a considerable amount of randomness in financial markets which makes short term evaluation of trading results or behaviour irrelevant. We need to focus on the results of at least 30 consecutive trades over a reasonable period of time. This becomes difficult for people who hold positions for very long periods. The duration of the feedback loop becomes too long to be of much use in any sort of practical training.
Consider the Enemy
Trading is a game where one person’s win is another’s loss. Your enemy is not your neighbour down the street who is trying to do much the same thing as you or even other retail traders in general.
The enemy is the market makers and big institutional trades who drive and control the markets. They obviously want you and all other retail traders to lose so that they on average can win.
Because they have the ability to manipulate and move markets they can create market situations and setups that they know are likely to trigger cognitive biased based behaviour in the vast majority of retail traders. Realising that these guys are out to get us through psychological manipulation puts us more on our guard about what is going on in our minds. In time we come to realise that we have the choice to not only avoid getting sucked into their games, but the ability to take them on and beat them at their own game.
Consider Your Instincts
Our objective is to make reasonable and rational trading decisions, but if you ignore or suppress your instincts they will inevitably just overpower your conscious mind and force decision which are likely to be heavily influenced by a cognitive bias. This sounds all rather “touchy feely” but we do need to be in touch with our feelings, particularly those in our abominable region i.e. “gut feelings”. This area of our body is full of nerve endings. A significant amount of our subconscious communication takes place through physical sensations in our gut. We are not trying to get rid of our cognitive biases, we are trying to develop the neural facilities to manage them.
Give Yourself Time to Think
Our instincts, including cognitive biases, typically use very simple rules that enable them to operate much faster than reasoned thinking. They have been referred to as fast and frugal. This means that our instincts can come up with a response to a situation while the conscious mind is still processing the information. Our conscious mind, perhaps a bit overwhelmed by this instinctive blind siding, then comes up with a story as to why that unconscious decision was made. We call that process rationalisation. This story, however, is often untrue. When we lose money as a result of these persistent self-lies, it can be annoying to say the least.
Unless we are trading extremely short time frames, there is always a reasonable amount of time to think through a decision. This engages the PFC executive function and effectively says to this part of the brain that it needs to check things out before allowing this decision to be acted upon. Developing this facility is a major part of what this cognitive training is all about. It eventually enables us to consistently make reasoned decisions rather than impulsive ones.
Make the best possible decision you can and then act
Cognitive biases may not only cause us to act in ways that are counter-productive, but can cause us to not act at all when we should. A classic example is the tendency to hold on and hope with a position that is going against us rather than closing it out and taking a managed loss. After having thought through a situation, it is essential to discipline ourselves to carry out that decision. I believe this accounts for the commonly reported phenomena that doing the right thing often feels acutely uncomfortable.
Patience, Perseverance, Self-Discipline, Willpower
Our brains, unlike computers, cannot be changed instantly at the push of a button. Change happens organically. The new network of neurons that we need to build to handle the complex decision making involved with trading is more akin to growing a tree starting from just a seed. The brains of babies and young children grow very quickly, but as we get older, this process slows down considerably. Since many people don’t take up trading until quite late in life it may take many months or even years to develop a traders mind. This is where self-discipline, willpower or whatever you want to call it, comes in. You simply have to keep working at it on a consistent and regular basis until the necessary neurological development has taken place. We live in a world of instant gratification so this is probably the most difficult part for most people. It is common knowledge that many people give up their attempts to become retail traders after a relatively short period of time and a good deal of the time spent trying to become successful is wasted looking for some secret formula, strategy or technique commonly referred to as a “holy grail”.
There is a holy grail for trading, but it is within each individual. It results from the personal transformation of the neural structure of our brain from the default crowd mind set to that of the altogether more evolved state of mind of a skilled and experienced trader.