Traders who make money consistently over the long run are rare. If you want to join their ranks, you need to cultivate a certain mindset. One recent book – not actually about trading – that I’ve found particularly helpful, is Daniel Kahneman’s Thinking, Fast and Slow. Kahneman’s basic thesis is that we have two modes of thinking that can be in conflict: system one is intuitive, knee-jerk and fast; whereas system two is considered, rational and slow.
The key is that we are not always the rational, maximum-gain seeking, loss-avoiding agents that form the foundation of classic economic theory. Far from it – we are often irrational and emotional, with poor choices the result. In a market context, it is these poor choices that produce the extremes of herding (where almost everyone is betting on one outcome) that we invariably find at major tops and bottoms.
Kahneman quotes a classic experiment that shows very clearly how poor our decision-making can be. Take a look at the questions below, and choose one option for each (your profit or loss is based on the combined outcome):
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1. Pick one:
A) A sure gain of £240B) A 25% chance to gain £1,000, and a 75% chance to gain nothing
2. Pick one:
C) A sure loss of £750D) A 75% chance to lose £1,000, but a 25% chance to lose nothing
No choice is especially attractive here, but if you are like most people, you would be instinctively drawn to the sure gain of A, and repelled by the sure loss of C. In Kahneman’s original experiment, a whopping 73% of people chose the combination AD. This automatic, emotional reaction is a product of System 1. But System 1 decisions can be poor ones.
You see, if you do the calculations, the most favourable option statistically is actually BC. The expected value of AD is negative £510, while that of BC is a slightly better negative £500. That surprising result required the brain to do considerable System 2 work, and that is too much for most people. What is the lesson for traders? It’s not “swot up on statistics” – the real lesson is that which seemed obvious (that AD is best), is incorrect. Herds gather in markets, because there is an ‘obvious’ story that System 1 can easily identify with – such as ‘house prices always go up’, for example.
This confirms legendary trader Joe Granville’s maxim: “When it seems obvious to most people, it is obviously wrong.” The nice thing about this is that because we know that System 1-driven herding in markets eventually produces the ‘wrong’ answer (trends change when the herd gets too big), then to answer the question: ‘Which combination is best?’, all I needed to know was the fact that 73% of respondents chose A and D. It’s odds on that a different combination – most likely the exact opposite, BC – was correct. This is classic contrarian thinking.
In short, a good trader does not want the market to prove them right in their views so they can brag to their friends; they want to discern what other traders are doing, and if they are in a large herd, trade against them. To think like a trader, use your System 2 analytical mind to examine your knee-jerk, gut-feel System 1 answers that seem obvious, but may not be.
Daniel Kahneman, Thinking, Fast and Slow (Penguin Books), RRP £6.99. Read more from John C Burford at moneyweek.com/trader
