Average CTA’s, investors, and people generally have an overwhelming desire to be “right.” Who likes to be wrong? You read and hear daily from friends, and fellow traders (spouses – J), how important it is to be correct, especially when they make a market prediction or, even worse when they put real money into a trade.
The amount of information an average CTA is exposed to and has to process daily is staggering. And the scientific fact is that the human mind can only focus on one thing at a time and take in so much information before it is lost. That’s how professional Magicians / “Street Hustlers” make a living – Misdirection. They get your brain focused on one thing while pulling off their grand illusion without you even having the slightest clue how they did it. As a result, we tend to develop “shortcuts” to thinking and visualizing, helping us cope with the multitude of information we are continually exposed to. These “shortcuts” are very useful under most circumstances, however, the implications for investors or CTA’s of this mindsets can be most detrimental, and make the probability of being successful in the markets practically zero, unless he or she can deal with these “goblins”. The “goblins” I am referring to are mental biases which are part of everyone’s make-up and just plain human nature, and there are 13 (lucky number), of them which I will list for you and give a brief explanation.
#1: Reliability Bias: This is a bias where a person may assume something to be accurate when it possibly may not be. Example: Statistics and information you may use for back-testing or that comes to you across CNBC, Bloomberg, or the internet are very often filled with inaccuracies. Unless you can wake up in the morning and know that the possibility for bad data and misinformation can and does exist, it will set you up to make countless errors in your trading & investing decisions.
#2: Lotto Bias: Every CTA or investor deep down wants to “control” the markets and specifically price action, and so most totally focus on “Entry”, where they can coerce the market to do a lot of things before they jump in. However, once the position is established, price action is going to do what it is going to do. As Ed Seykota said: The golden rule to trading is “Cut losses, Cut losses, Cut losses, and then you may have a chance”.
#3: Representation Bias: CTA’s and investors will assume that when something is supposed to represent something else, that it is reality. Therefore they assume that a daily candlestick chart is the entire market or that a Fibonacci number is the entire picture. Instead, that is really just a shortcut for interpreting a whole lot of information.
#4: Randomness Bias: Investor’s & some CTA’s love to assume that the market is random and has many patterns (double bottoms, Head & shoulders, Spikes, etc.) that are easily tradable. However, in my opinion the markets are not random. Price distribution does show that over time markets have an infinite variance, or what guys with PHD’s. call “long tails” at the end of a Bell Curve. What they fail to understand is that even “random markets” can have long “streaks” and as a result trying to pick tops and bottoms can be a road to disaster.
#5: Law-of-small numbers Bias: CTA’s, investors and traders alike tend to see “patterns” where really none exist, and in reality it only takes one or two occurrences of this “pattern” to prove and convince a person that it is a “fact”. When you make a cocktail of this particular bias, with a Conservatism Bias (read below) it could create a virtual tinderbox ready to go up in flames.
#6: Conservatism Bias: Once a trader or CTA believes they have found a “pattern” and is convinced it works (by means of cherry picking or selective memory), they will do everything under the sun to avoid scenarios, situations, and confirmation that it does NOT work.
#7: A “Need-to-Understand” Bias: Every CTA or trader has a need to attempt to make order out of price action in the markets and find a rationale and reason behind it. This effort, to “find order” will hinder that CTA’s ability to go with the flow or follow the trend because, for lack of a better phrase, see what they want to see rather than what is truly happening in front of their eyes.
These are the first 7 out of 13 trading / investing biases that many CTA’s and traders are prone to. Again, it is built into our DNA and is human nature. Knowing and realizing them is the first key to unlocking the door to better investing and improvement. I will follow-up tomorrow with the remaining 6 mental blocks that may be holding you back from above average returns in the markets.