Saturday, October 17, 2015

The Greatest Mistake Losing Traders Make

One of the greatest mistakes traders make is to allow their thought processes to get noisier as they lose money.  They double down in their thinking about the market; they scan even harder for winning trades; they vent emotions about their losses.  In short, they turn up the volume on their cognitive processes.

The core issue here is whether your trading is a performance skill like golf or a knowledge skill like mathematics.  If I'm encountering difficulty with a math problem, I want to think harder and more creatively about finding the solution.  Math requires explicit knowledge and problem solving.  Golf, on the other hand, is more of an implicit learning skill where thinking more and harder frequently interferes with what the body knows.  That creates the "yips".  

If my trading is completely rule-governed and mathematical, a period of bad trading results probably means that market regimes have changed.  In that case, I want to double down on my market analysis and see where patterns of trend, volatility, correlation, etc. have shifted.  Analysis in that situation facilitates adaptation.

If my trading is intuitive and based upon pattern recognition, a period of bad trading results also could mean that market regimes have changed.  Doubling down on analysis, however, facilitates paralysis; explicit processing interferes with implicit performance skill.  Thinking harder about why your audience is not responding to the speech you're delivering will only interfere with your delivery and make the situation much worse.  

My theory is that investment is an explicit performance domain.  Trading is based on implicit learning and performance.

When traders encounter problems and shift into the cognitive mode of investors, they lose touch with their implicit, pattern-recognition skills.  It's not simply that they overthink.  They shift to the wrong information processing mode.  In a literal, cognitive sense, they are out of their right minds.

Here's a great article for you:  it's about teaching golf through implicit learning.  The article cites a study in which two groups were taught putting skills.  One group was given detailed instruction; the other group was given ample practice and left to figure out what to do on their own.  When tested, the first group displayed greater knowledge of putting, but in subsequent performance, the first group did not outperform the second group.  Indeed, in pressure situations, the group that was taught how to putt was more likely to choke than the group that learned through experience.  

Why was that?

Under stress, the explicit learning group went back to their instruction and focused on what they should be doing.  That shift to explicit thinking interfered with the performance skill and led to the choking.  Amplifying the volume on their cognitive processes provided interference, not inspiration.  The implicit learning group had no lessons to focus on and were more likely to rely on muscle memory, reducing the likelihood of choking.

The big takeaway from all this is that, if your trading is based on pattern recognition and a feel for markets, you want to become quieter when you encounter problems, not noisier.  In finding the quiet beneath our 50,000 daily thoughts, we can apprehend the new patterns being displayed by markets and pick up a feel for them.  

The worse you perform, the quieter you want to become.  If you're a trader, not an investor, never let your thinking interfere with your information processing.

Further Reading:

Implicit Learning and Performance

Implicit Learning and Self Regulation