We treat trading as a business and every business needs a business plan to be successful.
Prominent financial author Jack Schwager in his Market Wizard books concluded that the one thing the super traders he had interviewed all had in common was a trading plan, methods, strategies, and systems.
When they stuck to it they were okay; when they didn’t, things started going wrong, usually resulting in various financial losses.
Imagine you have a bat and a ball. Together they cost $1.10. If I posed the question – “the bat costs a dollar more than the ball. How much does the ball cost?”.
Most of you would be thinking $0.10. Some of you might even be thinking I’m trying to trick you.
Here’s the answer: together they cost $1.10, the bat costs a dollar more than the ball, so the bowl costs 5 cents.
I just asked you to make a decision about the cost of the ball. This takes us right into the world of human decision making in the field of trading psychology.
As humans, we make decisions at two levels. Firstly there’s the intuitive subjective level, “System 1” as it’s called. It’s quicker, easier and gives us our first impressions.
“System 2” is the more rational, reasoned, rules-driven approach. It’s slower, more considered.
For most people who answered the question I posed earlier, you’d need to reach for a pen and paper to work it out but you probably already had 10 cents pretty firmly entrenched in your mind.
Daniel Kahneman, after many years of research with his now late colleague Tversky, Kahneman was awarded the 2002 Nobel Prize in Economics in the field we now know as Behavioural Finance.
Let me remind you that the Nobel Prize is not tossed around lightly. Whatever is discovered has to be both substantial and proven. So with that in mind, here is what they found.
In an environment of uncertainty such as the stock market, people tend to make System 1 type judgments rather than the more rational System 2 decisions. Their research went on to show that these System 1 type judgments are often biased, or worse, just plain wrong.
In our normal lives, we have the skill sets and the experience to make good decisions. In the stock market, however, left to our own devices, the same cannot be said.
The reason is that we don’t know how to get to the System 2 level of decision making. It’s too easy for our emotions to sneak in and affect the way we think.