Understand behavioral science and psychology to boost your consistency

The cheetah, while the fastest animal on the African plain can outrun any of the prey it feasts upon, always chooses to go for the young, weak, or sick. Once identified, he attacks with laser-guided focus and effectiveness. It is only then that the kill is likely. This is the epitome of a professional trader. Be the cheetah.

 

 

Here are some common questions I get from people:
“Sometimes I can’t find good setups in the market, should I trade the less optimal setups or should I look for more different stocks to trade?”
“The setup I learnt from xxx course was working fine a few months back, but it doesn’t seem to be working now. Should I continue using it?”

 

So, how do we go for the kill?

As cheetah, we should always go for the easy trades. But quite often, for the newbie, the easy trades are staring them right in the face but they do not see them. This is because they are only familiar with a few simple setups (with simple rules/formula) that work best only under specific market conditions.

All these questions have a common theme. Traders who learn one or two simple setups think that they can trade successfully, but when the market changes, quite often the simple setup or system that they are using cannot adapt to the market, and becomes discarded.

Hence, a good trader cannot keep relying on the one same setup. Rather, he needs to know the basic form of a setup, so that from there, he can create a wide variety of different setups that are best suited to the current market situation. That is why we teach a variety of setups (and certain proven variations), leaving them the core skills to tweak setups to adapt to any market situation.

Some of you might have heard the term before, but are not really sure what it means. So what exactly does self-actualisation mean?

Maslow's Hierarchy: Trading Self-Actualization

Maslow’s Hierarchy: Trading Self-Actualization

The term originally came from Maslow’s hierarchy of needs, which represents the things people strive for as they grow and evolve. As we progress from basic needs like food and shelter to more complex ones like esteem and knowledge, what awaits at the top is self-actualization.

Simply put, it is reaching your full potential, and in the context of trading, it means being able to become the “ideal” trader which you envision.

If you’re been trading for many years, you should have acquired many different skills and experience. But are you putting these to good use? How is it possible for you to reach your full potential?

The key lies not in using everything you have learnt, but rather in knowing what is not essential. Once you learn to think in essentials, you will realise that you will have to discard most of what you have learnt, and focus on the 10-20% that works. Clinging on to old baggage will slow your progress.


Now, I want you to visualise a circle. Label this circle “Current Reality”. This circle represents what you are currently like – your habits, your style, your results, your skill level, and your attributes. Take some time to do some self-reflection, and figure out what is wrong.

Next, visualise another circle which partially overlaps the first circle. Label this circle “New Reality”. This circle represents what you want to become, and is a blueprint of the “ideal” trader which you have envisioned, and embodies all the essential attributes of such a trader.

The overlapping region is the zone of self-actualization. 


Let me give you an analogy. If you want to lose weight or get fit, the “Current Reality” could be someone who does not exercise and eats unhealthily, while the “New Reality” is picture of the gorgeous body you saw in some health magazine. The zone of self-actualization is then simply the series of steps you take to bridge the gap between dreams and reality.

Insanity is doing the same thing over and over again, and expecting different results. This means taking the time to learn from your mistakes. The bottom line is, if you want different results, something has to change.

Although I ended with a small loss at the end of the day, I felt that this day was a victory. Before you think that I am crazy, let me explain.

Because of the probabilistic nature of trading, it is necessary to have losing trades. Depending on the style of trading, it is highly likely to have losing days as well.

The skill of a trader lies not just in being aggressive and swinging for home runs on good days, but also in being able to stay emotionally grounded and minimise losses on bad days. By bad days, I mean those days which the market does not match your trading style.

There were a couple of times where my setups, timing and entry were flawless, but I lacked the conviction to hold onto my positions, and I ended up only taking a small profit, after which the price continued to run for another 3-5 times of the small profit I took.

My maximum drawdown was very close to US$1,500, which I would have stopped once that amount was hit. But I managed to recalibrate my mental state by cutting losses, getting out, and taking a break. When I came back, I switched to a defensive trading style to adopt to the market conditions, and managed to reduce my losses to under US$500.

At the point of a large loss, I have seen many traders self-destruct by taking huge gambles to “make back” their losses. This becomes irrational trading, and you no longer have the edge. It becomes gambling. If you are wondering what the difference is, you can read this article about trading and gambling.

To a trader, consistency is key. By consistency, I mean consistency in analysis ability, as well as mental stability. A good intraday trader typically has 4 winning days out of 5 trading days. In addition, the winning days should be a lot larger than the losing days.

Hence, keeping your losing days small is also an essential skill.

People exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to forestall the pain of regret associated with poor decision-making. It is a cognitive phenomenon that often arises in traders, causing them to hold onto losing positions for too long in order to avoid admitting errors and realizing losses.

 

 

Regret aversion also makes people unduly apprehensive about taking positions after a string of losses, as they feel instinctively driven to conserve, to retreat, and to lick their wounds. This might cause them to hesitate most at moments that actually merit aggressive behaviour.

This can also affect a person’s response to winning positions. For example, traders might be unwillingly to sell an in-the-money position despite negative signals, choosing to cling on to it because they fear that the stock might continue to soar even higher once they sell it.

People who are regret-averse try to avoid distress arising from two types of mistakes, (i) errors of commission and (ii) errors of omission. The former occurs when we take misguided actions, while the latter arises from misguided inaction, that is, opportunities overlooked or foregone.

The other danger comes from “herding behaviour” where traders simply try to follow the crowd, since following the mass consensus diffuses responsibility and hence the potential for future regret.

What is the best solution for this?

The way out of this is to have confidence in your methods and your skill, so that despite a string of losses, you will still be able to trade consistently, because you know that in the long run, you will be able to recoup those losses and turn up a profit when you manage to catch the big moves. The key here is discipline and consistency.

“I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret, so I split my retirement plan contributions 50/50 between bonds and equities.” – Harry Markowitz, father of Modern Portfolio Theory

 

Described in simple terms, hindsight bias is the impulse that insists: “I knew it all along!” Once an event has elapsed, people afflicted with hindsight bias tend to perceive that the event was predictable – even if it wasn’t. This behaviour is precipitated by the fact that actual outcomes are more readily grasped by people’s minds than the infinite array of outcomes that could have but didn’t materialize.

Therefore, people tend to overestimate the accuracy of their own predictions. This is not to say, obviously, that people cannot make accurate predictions, merely that people may believe that they made an accurate prediction in hindsight.

 

 

This affects future forecasting, because a person subject to hindsight bias assumes that the outcome he or she ultimately observes is, in fact, the only outcome that was ever possible. Thus, he or she underestimates the uncertainty preceding the event in question and underrates the outcomes that could have materialized but did not.

One detriment of hindsight bias is that it can prevent learning from mistakes. People with hindsight bias connected to another psychological bias, anchoring, find it difficult to reconstruct an unbiased state of mind, simply because it leads people to exaggerate the quality of their foresight.

When hindsight-biased traders have a winning trade, they tend to rewrite their own memories to portray the positive developments as if they were predictable. Over time, this rationale can inspire excessive risk-taking, because they believe they have superior predictive abilities.

Hindsight-biased traders also “rewrite history” when they fare poorly and block out recollections of prior, incorrect trades in order to alleviate embarrassment. This form of self-deception, in some ways similar to cognitive dissonance, prevents traders from learning from their mistakes.

What is the best solution for this?

In order to overcome hindsight bias, it is necessary, as with most biases, for the trader to understand and admit their susceptibility. One way to face the facts is to keep a trading journal, and use it to record your analysis and reasons for every trade, as well as the thought-process and emotional swings that went with the whole trade. This will be useful when you look back to the past after the event, and will prevent any disillusioned thinking.

“You didn’t know it all long; you just think you did.”

– James Montier