Sunday, August 02, 2015

What We Know, What We Feel, and How We Trade

One of the great challenges of trading is reconciling--and integrating--two modes of knowing:  the explicit and the implicit.  Explicit knowledge is what we readily verbalize as part of reasoning processes.  Implicit knowledge is what we feel and sense as part of intuitive processes.  We navigate life through a complex interplay of these modes of processing.

I recently fielded a phone call from one of my daughters who described stomach pains she was feeling.  I walked her through a few questions to try to establish the possible cause of her pain.  My first hypothesis was that she might be experiencing a gastroenteritis due to food poisoning, so I asked questions relevant to sharp pains, nausea, what she had recently eaten, etc.  That is explicit reasoning at work:  I am drawing on a database to establish a cause-effect relationship.

While going through the questioning, however, I heard real distress in her voice.  She had called me in the past about not feeling well, but the tone of her voice was different this time.  My immediate sense was that this was a serious problem and that *she* was sensing it was not a normal stomach pain.  That is implicit reasoning at work:  I am drawing upon a database of experience with my daughter to recognize a pattern.

Because of the intuition regarding distress, I began asking questions about the *location* of her pain.  Sure enough, it was a bit more painful on the right side.  It was also tender there.  Right away, I told her of my concern regarding possible appendicitis and the importance of going to the ER for evaluation.  She took prompt action and, within a few hours, was in surgery:  explicit and implicit reasoning led to a helpful plan of action.

All of life inevitably involves our two information processing modes.  We hear people talk, and we read their non-verbal communications.  We research the car we want to buy, and we get a feel for the car when we test drive it.  We think, we feel, and at the end we integrate.  Insight lies at the intersection of what we know and what we feel.

Different forms of trading make different use of these cognitive modes.  At one extreme, algorithmic trading makes use of formal analyses with no subjective evaluations of markets.  At the other extreme, the pattern recognition of rapid daytraders makes little or no use of formal analyses.  Both can make money, because both can reflect genuine knowing.  Both can also be vulnerable, because markets are not static entities.  We become vulnerable when we are so grounded in formal models of past markets that we have no feel for shifting market conditions.  We also become vulnerable when our feel for recent market action is blind to fundamental developments that radically alter the flows of supply and demand.

Do you formulate a plan and trade your plan?  Do you trust your gut and trade what you see?  It's easy to find gurus whose advice falls on either side of the explicit/implicit divide.

Perhaps trader problems occur, not so much because of lapsed discipline, as because of difficulties finding an optimal integration of explicit and implicit knowing.  Caught between their brains and hearts, traders struggle in markets for the same reasons most of us have struggled in romance.  When we feel strongly, we can make decisions that are relatively brainless.  When we make decisions strictly from our brains, we can end up with practical choices, but not inspiring ones.

If you've traded for a while, you no doubt have experienced occasions in which what you know and what you feel come together and you have an unusually profitable opportunity.  It's like the situation in which my pattern recognition of my daughter's distress and my knowledge of appendicitis line up and immediately result in a useful course of action.  Our best decisions in life speak volumes as to the ways in which *we* ideally integrate explicit and implicit knowing.  Deconstructing our best trades points the way toward how we uniquely harness the power of dual information processing.

The goal is to place these modes in harmony, not in mutual opposition.  But we cannot achieve harmony unless we spend enough time to assemble a knowledge base for explicit reasoning and an experiential base for pattern recognition.  Beginners at trading fail for the same reason that beginners would fail in a chess or golf tournament:  they simply lack the database of understanding and experience to make sound decisions from head or heart.

Further Reading:  Making the Right Decisions in Life and Trading