For many years, the publishers of how-to guides for financial market novices were fond of plastering the front cover with a question for would-be readers along the lines of: “Do you seriously want to be rich?”
Assuming the answer is “Yes,” then one sure-fire way for traders to fail to achieve this goal is to succumb to a series of all-too-common fallacies or delusions that can cost you money.
Some are obvious, such as relying on superstition to guide your trading choices or devising trading strategies based on political ideology. More dangerous are those that can appear to have some rational basis, but are, in fact, as illusory as the most blatant fallacy.
Here are five of the most common, and the most perilous from the trader’s viewpoint. Remember that however superficially attractive they may seem, they have no relationship with reality and can prove costly.
1. The fallacy of seeing patterns where none exist. It is tempting to look at past trading data and back-fit patterns on to the price movements that we see. After all, if we have spotted a repeatable sequence of price changes, that would give us an edge in future trading. But while there is value at noting support levels at the bottom of a trading range and resistance points at the top, these should be used for guidance only. By definition, no trading range should be assumed to stay in place indefinitely. More damaging still would be to use the data to draw elaborate patterns that then inform trading decisions. Almost certainly the picture you see is the product of your mind’s eye.
2. The “my turn” fallacy, a branch of the well-known “gambler’s fallacy”. The latter posits that a long run of one outcome, such as a string of heads in a row when tossing a coin, makes increasingly likely the opposite result to “make up” for all the heads. Of course, the coin has no memory and no consciousness that it is supposed to compensate for all those heads. The “my turn” fallacy applies this to the individual trader and suggests the market is obliged to make up for a sequence of poor outcomes with some better ones. Alas, the market has no memory either. Whether talking of tossing coins or pricing assets, the next result will be quite independent of what has gone before.
3. The “winning streak” fallacy. Perhaps the mother and father of them all. It goes hand in hand with notions such as “lady luck”, the wheel of fortune and the trader being, in some unexplained way, “hot” on a particular day or trading period. It is all nonsense. If a series of trades perform well, that has nothing whatever to do with its “hotness” and everything to do with one of two things – either your trading strategy is soundly based and well carried out, or it is neither of these things but the strategies of other players in the market are even less so. The “winning streak” fallacy has probably cost more traders more money than any of the others.
4. The “being owed” fallacy. This particular delusion can seriously damage your wealth. It is based on the notion that an asset “owes” it to you to come good, often in proportion to the amount of time and money you have put into the strategy in question. A mixture of irrational lines of thought feed into this fallacy. There is the idea that cutting losses now would make more likely a turn-around in performance, what may be thought of as the “darkest hour is before the dawn” sub-fallacy. There is the notion that it is “wrong” to walk away from a strategy in which so much has been invested. And, of course, there is the delusion that the strategy is in your debt and has to pay you what it owes. It isn’t, and it doesn’t.
5. The emotional trading fallacy. There should be no likes or dislikes among financial assets. They are a means to an end, which is making you, the trader, wealthier. But you’d be surprised how often even experienced traders express a fondness for this or that asset – a currency, a stock, anindex or a commodity– or an aversion to the same. These assets have no feelings towards you; they are not trying to reward you or trip you up. They are not trying to do anything. Of course, sound knowledge and experience of one particular asset or asset class may rightly dispose you to trade in this area than somewhere where your knowledge is not as deep. But that is very different from developing a personal attachment to assets. In the film The Day of the Jackal (1973) the Edward Fox character warns a hapless group of failed assassins: “You can't afford to be emotional. It's why you've made so many mistakes.” Sound advice.
There is a common theme running through our five fallacies, the delusion that assets and markets are sentient beings with independent feelings and behaviour patterns.
In November 2014, academics at Nottingham University studied the second and third of our fallacies and warned: “Financial markets are especially interesting because the wrong decisions are potentially very costly, so they offer a strong incentive for traders not so succumb to psychological biases in decision-making.”
They added: “Unlike at the roulette wheel or in the choice of lottery numbers, where players’ choices make no difference to the chance of success because the underlying process is random, in financial markets such biases can prove to be very costly if they do not match the underlying dynamics of prices.”
In other words, if you seriously want to be rich, then there should be no room in your strategies for fallacies and delusions.