Thursday, October 25, 2007

The Psychology of Behavioral Premises

I'm going to try to explain an important psychological concept and why it's of paramount importance to trading. The concept is something I call "behavioral premises". A behavioral premise is a rationale for our actions; it's the set of assumptions that drive our choices and responses in various situations. The network of our behavioral premises represents our belief system about ourselves, others, and the world around us. These beliefs may not be enunciated, but they are the filters through which we perceive the world, thus coloring how we respond.

An important principle is that our behavioral premises tend to evoke responses from other people that, in turn, reinforce those premises. That is, people's responses toward us will be shaped, in part, by how we approach them--and the beliefs that underlie our approach. Here are a few examples:

* A person has been hurt in past relationships and doesn't want to face rejection again. Her behavioral premises are that relationships are dangerous and that others don't really care about her after all. As a result, she maintains a guarded stance with people who might otherwise want to get to know her. Seeing that she is not approachable, others keep their distance from her and make no effort to open up themselves. This reinforces her premise that people are uncaring and unavailable, convincing her that she must stay all the more guarded.

* A job applicant believes that he has no chance to land a desirable position. His behavioral premise is that he lacks the charm and personality to come across well in an interview. As a result, he is nervous throughout his visit to the firm and comes across as unsure of himself. Sensing this, the interviewer concludes that he won't be an effective representative of the company and turns him down. This confirms the man's belief that he is not cut out to be hired for a good job, and he approaches the next interview with even less confidence.

* A businessman is convinced that others are out to cheat him. His behavioral premise is that he needs to be on guard at all times, because his employees can't be trusted. He establishes strict rules and maintains stifling oversight of his employees, even after their training phase has been completed. The employees, feeling untrusted and not valued, leave the business one by one to find a more suitable work environment. This convinces the businessman that he's right; that employees will just take his training, use him, and move on. As a result, he trusts the new group of employees even less.

Notice that each of these scenarios is one in which there is a vicious cycle. The behavioral premise leads to actions that bring outcomes that reinforce the premise. This is one major reason people stay stuck in self-defeating patterns.

The same dynamics occur in trading. Imagine that, feeling like a defeated trader (per the recent post), you act on the behavioral premise, "I just can't make money in the market." You follow your rules, enter a trade, and it moves a few ticks against you. This only reinforces your negative belief and you quickly exit the position before the loss becomes too great. Meanwhile, the market chops around a bit before eventually moving in the direction you had anticipated. All you can do is shake your head: your premise has proven true once again.

So how do people escape from these vicious cycles? Most people can't talk themselves out of their premises; they need direct, powerful emotional experiences to show them that their beliefs are wrong. This is one reason I emphasize solution patterns with the traders I work with. We spend extra time examining trades that have worked out and isolating what the trader did right on those trades. By creating a model for good trading out of these successful trades, we increase success and disconfirm negative behavioral premises.

One of my favorite exercises is to look at what happened in the market after exiting a trade. Very often the basic trade idea was right all along; it was the timing that was off. This also disconfirms negative premises. The message is that it's not that you can't read the market; it's just that you need to refine your execution: when you enter, how large you enter, and where you stop yourself out. I've often seen big results from such seemingly small refinements. Why? Because the process of making those refinements challenges the behavioral premises that led to the "stuck" patterns to begin with.

We will always live up to our most deeply held behavioral premises--for better or for worse.


Solution Focused Trading

The Question to Ask When You're in a Slump