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.