The perfect trader– cool, analytical, disciplined. They navigate the markets with ease, make decisions based on facts, and profit from all the trends and market changes that they come across.
But, does this perfect trader exist? Of course not! Emotions, biases and psychology are part and parcel of the human experience and affect our ability to trade rationally. So, how can a human be expected to trade successfully? How can a trader reach near-perfection?
Humans did not evolve to trade
Accounting for 2% of our overall body mass, the human brain is one of the largest in overall size. It is three times larger than that of a chimpanzee’s and to function effectively it uses a massive 20% of the body’s energy. Scientists suggest evolution caused a trade-off from muscle mass to brain power, which should be good news for intelligence, but is it so simple?
Not quite. Whilst overall intelligence is a contributing factor, brain evolution is highly specialised. From ancient times, the brain has developed hugely to meet the ever changing survival needs of man. From fight-or-flight skills necessary for primitive survival, to the development of agriculture, modern society, and sovereign states.
That brings us to heuristics. These are learned methods of problem solving and learning that help us interact successfully with our environment, such as knowing what’s acceptable attire for a job interview, and what’s seen as pretentious.
Whilst helpful in navigating the ups and downs of life, this combination of the learned behaviour of heuristics, and the nature of evolution creates a classic case of maladaptive behaviour for traders. Evolution simply hasn’t caught up with the modern world, at least not quite yet.
Similar to how sea animals can mistake translucent plastic in the ocean for jellyfish and ingest it, traders can fall prey to nature and nurture. Let’s delve deeper and explore how this can affect trading.
Irrationality and biases
We all like to believe that the decision we make are rational. Unfortunately, this is not always the case, and we’re often swayed by other factors. Emotions, our environment, our previous experiences, and even the information or lack off that we have all significantly affect the decisions we make.
A useful adaption in ancient times, when the consequences of taking a risk for our hunter-gather ancestors could include the loss of a limb or death. The world of trading, whilst exciting, is not quite so dramatic. Risk aversion in trading leads to traders not taking risks, or even staying in ineffective trades too long. In short, they are making irrational decisions.
Another example is herding bias. Whilst there is safety in the herd and, generally speaking, following the trend is a good idea, herd bias can be fatal in trading. Characterised by ‘panics’, it is the almost animalistic behaviour of people in times of crisis.