Friday, June 15, 2007

Trade Like a Scientist - Part One: The Scientific Mindset

A theme I emphasize with new traders is that it is important to trade like a scientist. The scientific mindset is one that can be rehearsed and cultivated--and eventually internalized.

What do scientists do? First, they observe regularities in nature. They look for patterns: repeated sequences of events and commonalities among structures. Those regularities differentiate what is meaningful from what is random.

After observing regularities, scientists attempt to explain these. Explanation is the role of theory. The theory is the scientist's way of making sense of the world. Theory is not truth; it is a first approximation at truth.

Scientists gain confidence in their explanations by testing them. If a theory is meaningful and accurate, we should be able to use it to generate future observations. These predictions are hypotheses for the scientist. By testing hypotheses, we keep an open mind with respect to our observations and explanations.

Finally, once empirical tests provide fresh observations, scientists revise their explanations of nature and use these to generate further hypotheses, observations, and revisions. Knowledge, for a true scientist, is always provisional: that is what separates science from dogma.

The scientific mindset is one of humility: a recognition that our best theories are only approximations and that many of our tests of hypotheses are apt to fail. When we trade, we have an implicit or explicit theory about the current market, and our trade tests a hypothesis that we frame around our explanation. That is why a scientific trader never wagers too much on any single trade. Nature will always be more complex than our science, and our understanding will always be partial. Such a perspective is a powerful antidote to overtrading and overconfidence.

In my next post, we'll walk through a trade from a scientific perspective.
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6 comments:

Paulo De said...

Timely post, i just discovered that a very logic and reasonable trading strategy is not as good as i thought. After 3 months of trying, the data confirmed that there is no edge.
However by studiying that i´m preparing a reverse hypothesis.
I must add that scientific trader is time consuming and a never ending process.

nicker said...

Dr Brett
"Knowledge, for a true scientist, is always provisional: that is what separates science from dogma."
I like what you wrote.
There are bread and butter scientists who work to prove themselves right, then there are the rare true scientists who work to prove their hypotheses wrong. This gets interesting when, as when testing trading plans, we must think in probabilities of being right....traders' quantum mechanics, so to speak.
Nicker

bzak said...

I agree nicker,

You have to think like a scientists, but be aware of your own comfirmation biases.

Instead of looking for data the proves your own trading theories, you should try to disprove them.

Kathy said...

I agree that "scientific trade is time consuming and a never ending process. "

I have traded for 14 years. I still have no idea if I will win or lose when I place a bet.

I would say trading is only for people who enjoy the process. Or for people who can really win.

For most people, invest is the way to go.

circadion said...

Physical laws are less likely to change on you than the functioning of the market. Especially given that once you figure something out about the market, the act of exploiting it makes it less true. So I'd argue that the scientific method isn't necessarily the right approach to trading.

Brett Steenbarger, Ph.D. said...

Hi Circadion,

I think the problem here is the equation of science with physics and the physical sciences. When you examine concretely how science is applied in social/human sciences, the relevance to trading is more readily apparent: especially the interweaving of qualitative and quantitative methods.

Brett