Experienced investors always go by the rule that says “Don’t put all your eggs in one basket”.
Trading: fast and slow
2020-08-26 • Updated
Information is not investment advice
How many times did you make a decision without even thinking about it? Let’s face it – too many. Among these decisions, there are probably a lot of those you regret. On the other hand, thorough analytical thinking takes more time but helps you to understand complicated tasks. The difference between intuitive and analytical decision-making is the main topic of "Thinking, Fast and Slow", the book written by the famous economist and Noble prize winner Daniel Kahneman. This book describes how people make their decisions and why errors happen during this process. In this article, we will try to apply the main take-aways from the book to trading activity.
Two systems of thinking
According to the book, we have two systems of thinking – System 1 and System 2. The former system is automatic, and you implement it immediately. This is how your brain works: it sees the problem, compares it with the experience in the past, and offers you a solution. In some of the daily life situations, it takes only one blink of an eye to come up with a final decision. For example, how long does it take for you to understand that the smell that you feel comes from your favorite donuts? We guess, just a few seconds. Alternatively, system 2 requires more complex analysis. Here, you need to use your skills, knowledge, and a deeper work of your brain.
Let's look at how these two systems work in trading. For example, what an experienced trader may think of when he reads the news pictured below?
The first thought which springs to the mind of any trader is “It’s time to buy risky assets!” Your mind sorts out every risky asset you know (including stocks, commodity currencies, indices, etc.)
But what should you buy to avoid mistakes? To answer this question, System 2 turns on, and you start to analyze which assets are really worth trading right now. You look for confirmations, such as candlestick patterns, chart patterns, and significant levels. Only after a thorough analysis processed through System 2 you make your decision.
Simplifications based on System 1
Even though System 1 is generally accurate, there are situations when it lags. In fact, System 1 sometimes seeks an easier answer to questions than it was asked.
For example, after hearing about a bullish rally in the markets, you may jump into a trade without a second thought, followed by emotions and the fear of missing out. But despite your anticipation of success, the market turned in a different direction. That's because you skipped the important signals indicating the change of a trend.
WYSIATI: What you see is all there is
Another interesting aspect which Mr. Kahneman pays attention to is called WYSIATI – “what you see is all there is”. This phrase reflects a phenomenon of making conclusions based on limited information. As a result of WYSIATI, a trader may create false conclusions about the market based on a limited amount of information. Due to the automatism of System 1, our mind identifies seeming connections between the events. After that, the formed judgment or impression is confirmed by System 2.
As a result of WYSIATI, the following errors happen pretty often.
- Law of small numbers. Sometimes, all a trader needs is to look at the results of a small sample (i. e. 3 people) to jump to a final conclusion. For example, you saw the headline “According to analysts, the recession is coming”. You make an immediate conclusion that the recession is on the way, even though it is an opinion by three journalists who are barely related to economics. You would know that if you opened the article and paid attention to the text, but you were too busy with panicking and withdrawing funds. Therefore, to avoid this error in your behavior, you need to check the facts all the time. It's highly recommended to read the news and analytics carefully and be familiar with the original source.
- The connection between a random chance and a cause. This is the error we bet you often face in your trading practice, our dear technical analyst.
Remember the support or resistance level you considered too strong to break while expecting a rebound? All of sudden, that level got broken, and you lost your trust in statistics. As Kahneman wrote, “many facts of the world are due to chance, including accidents of sampling”. Hence, you should always see the bigger picture and understand what is going on in the market, what events are happening right now and track the risk sentiment. To read more about it, check the economic calendar and our tips on understanding risk sentiment.
- Narrative fallacy. People often create flawed explanations for past events. Remember the typical story of a successful trader? When you read it, you think: "Wow, this guy has trading in his blood!" What does not come to your mind is the background, which has a lot of accidental events, losses, and other buzzes a writer avoids telling about the uniqueness of a case. If you are not familiar with a narrative fallacy, you start to believe the narrator is a "trading guru", "successful expert" etc. That is why we recommend you to get inspired by these stories, but keep in mind that we are all human beings. You can’t become a trader from the book, but maybe you will create an even better story?
- Overconfidence. This traders' error happens quite often. It is also related to not knowing the background. Imagine you are a novice trader who has just learned about gaps. Some random post on Facebook mentioned that most of the gaps must be filled.
You open a chart of S&P500, wait for the gap, and…open a sell order. You forget that there are various types of gaps, including continuation and common gaps. The famous fact about filled gaps is related to common gaps, while continuation gaps happen during a strong uptrend/downtrend. As you trade S&P500 which is moving within an uptrend, you faced a continuation one and lost your money. So, we recommend you to get familiar with all the facts possible before entering a trade.
To conclude the article based on Mr. Kahneman’s study, let’s remember five important tips to avoid the mind tricks caused by System 1.
- Always confirm;
- Don’t make conclusions based on limited data;
- Know that all stories by gurus are designed to make you believe in their superiority;
- Even when you find a good trade signal by other people – try to explain why you are placing an order in here and not 100 pips above/below.
- Try to go deeper with facts you know. Learn all potential signs of reversal and don’t be fooled by your brain.
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