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.
Take bubbles. During Tulip Mania, the price of tulip bulbs kept rising due to the excessive demand, driven by the desire to make a profit. However, supply wasn’t able to keep up and sellers started defaulting causing the tulip bubble to burst. Those following the herd blindly stood the chance of making substantial losses, while those lucky few not involved were able to prevent such irrational losses.
The key factor is rationality, and to assess all perspective trades in this manner. But, how is it possible for a trader to break their biases?
Developing Homo economicus
Homo economicus – the ‘economic man’. Someone who is rational and follows their own self interests.
Don’t despair, all is not lost for traders hoping to improve their trading skills. Despite some natural disadvantages, traders can employ some smart trading tactics to improve their trading brains, step closer to homo economicus and become successful traders.
The best place to start is to learn. Seize any opportunity to improve your knowledge, skills, or experience. Read one financial article a day, then build on that, explore a new trading strategy or analyse your trading behaviour to see if you’ve fallen victim to any trading biases. Learn from your experiences and become a smarter trader.
Next, is to start maintaining healthy trading habits. Education is a good start, but it should be reinforced with market analysis, awareness of the financial ecosystem, and being conscious of your trading style. Analysing the markets will help you pick successful trades, and awareness of the financial ecosystem, including world events such as Brexit, can help you plan for unexpected market dips or rises. Knowing your trading style is also a key factor. Plan your trades, choose the ones that are right for you and your budget, know your risk aversion level and which biases you may fall for. Make these processes part of your trading strategy and you’re one step closer to success.
Stick to the plan, whether an individual trade is successful or not, you’ll have increased your trading knowledge for future trades and be on the path to building a successful strategy. But remember, plan for all eventualities, the losses as well as the gains. If your trade is obviously losing, don’t hesitate to stop, or better yet set stop losses to help you.
Follow these steps and you’ll be well on your way to developing your successful trading brain.