Tuesday, April 10, 2007

Countering Information Processing Biases In Trading

In a post a while back, I likened consciousness to a radio dial, with the various frequencies constituting our physical, cognitive, and emotional states. Powerful emotional experiences create very strong signals that dominate the radio spectrum, subsequently placing us in states that may interfere with our functioning. When those powerful experiences are positive, their dominance is crucial to the creation of addictive behavior patterns. When they are negative, their dominance is manifested as psychological trauma. One of the most important reasons for not trading too large for one's account size is the avoidance of roller-coaster emotional experiences. These lead to self-inflicted patterns of addiction and trauma that disrupt sound decision making.

On a smaller scale, markets create emotional experiences for traders each day. They do so with sudden large movements and shifts in volatility. Memory is not a democracy: not all memories are processed equally. We tend to place undue weight on what has occurred recently, and we tend to overweight emotional events. No doubt there are evolutionary reasons for these cognitive biases: cave man probably needed to focus on threats in the here and now to aid survival. The downside to this legacy is that, as traders, we can place more emphasis upon recent, emotional market events than is warranted by an objective look at market probabilities.

A great example of this is when we're stopped out of a good trade and then fail to take the next good trade because of fear of loss. Another example recently mentioned to me by an experienced, successful trader is getting excited by the recent volatility during the market decline and then overtrading the reduced volatility of the subsequent market bounce. I've been guilty of this myself: becoming so lulled by a slow, rangebound market that I take my attention from the screen and miss the subsequent, tradable breakout move.

Perhaps worst of all, recent emotional experience in markets can provide us with a negative edge in trading. I've written about short-term reversal effects in bull trends and bear trends: markets that have consistently risen over a multi-day period have yielded subnormal returns; those that have consistently declined have risen the most. When we overweight recent market experience, our thinking runs precisely counter to the market's own tendencies. Ever sold the exact low in a market or close to it? That's often a reason why.

I recently mentioned talking out loud as a way of changing our internal dialogues. If you follow my reasoning to this point, you'll see that talking out loud can also be a powerful technique for changing our biased thinking about recent market events. I suspect this is one reason many traders seek coaching: they're looking for someone to talk with to reprocess recent events and start with a relatively clean mental slate. But the efficacy is not in the coach, but the talking! In giving voice to our big picture market views and research, we consciously counteract any tendency to overweight recent market moves and P/L swings.

The same verbal recordings that can be helpful in rehearsing trade plans before trading and in reviewing performance after trading can be of help during market sessions--particularly when we make ourselves listen to what we've recorded. When we become the listener, we gain a measure of distance and objectivity with respect to our information processing. It is much easier to challenge a biased assumption when we hear it out loud than when we're identifying with it implicitly. The idea is to become a skilled observer of your own state shifts, so that you can consciously decide when to act upon them and when they are leading you astray. An audio trading journal can be a very helpful tool in developing this observing capacity.