Trade Like a Scientist - Part Three: Three Common Mistakes of Traders

In the first two posts in this series, we examined a scientific mindset and how it affects trading practice. Let's now turn the tables and view three common trading mistakes through the scientific lens:

1) Mistake #1: Trading Without Understanding - Sometimes traders put their capital at risk without taking the time to observe market patterns and integrate these into a concrete explanation of what is happening in the marketplace. A number of traders I work with observed the recent rise in interest rates very early in the move and formulated ideas of shorting rate-sensitive sectors. They tested their understandings with initial positions and scaled into the idea as markets confirmed their views. How different this is from simply putting a position on because a market is making a new high or low!

2) Mistake #2: Oversizing Positions - Many psychological problems in trading can be traced back to excessive position sizing. Traders trade too large for their account size in order to make windfalls, not in order to test their ideas. Scientists conduct many tests before any hypothesis is truly supported, and they test many hypotheses before they accept theories as versions of truth. If you were a lab scientist, would you risk your entire grant funding on a single experiment? Of course not; a single study could fail for a variety of reasons, including experimenter error. Similarly, any single trade or idea can fail for a variety of reasons. A true scientist knows that his or her understanding will always fall short of reality. That is why scientists will conduct doable experiments to refine their ideas before they dedicate significant resources to large investigations.

3) Mistake #3: Not Knowing When You're Wrong - A scientist does not actually test his or her hypotheses. Rather, each experiment is framed as a test of the "null hypothesis": the proposition that variables of interest do *not* affect the outcomes under study. Scientists thus never accept their hypotheses; they at best only reject null hypotheses. Embedded in this perspective is the idea that it is crucial to know when it is necessary to accept that mull hypothesis and conclude that a view is not supported. Can you imagine a qualified scientist becoming emotional because an experiment produces no significant differences and then conducting numerous revenge studies?! Traders, however, sometimes do just that. They don't have rational stop losses identified and so can't terminate their "experiment" at a prudent time. That leads them to take on excessive losses and react out of frustration rather than understanding.

A simple checklist would aid many traders who would become their own performance coaches:

1) What is my understanding of this market and what is the evidence behind it?

2) How much of my capital am I initially willing to devote to my understanding of this market?

3) What outcome(s) would lead me to devote more capital to my idea and what is the maximum portion of my portfolio I'm willing to put at risk on this idea?

4) What outcome(s) would lead me to abandon my idea and how much am I willing to lose on this idea?

Many bad trades could be avoided simply by requiring oneself to answer these questions aloud prior to any trade.