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Despite the importance of all the material I have presented about position sizing strategies, most people have psychological biases that will cause them to 1) ignore the material totally or 2) do exactly the opposite of what is recommended. As a result, I want to show you some of those biases and what you can do to overcome them.
Judgmental Shortcuts
French Economist George Anderla found that the rate of information flow with which we human beings must cope doubled in the 1,500 years between the time of Jesus and Leonardo DaVinci. By the year 1750 (i.e., in about 250 years), it doubled again. The next doubling only took about 150 years to about 1900. The onset of the computer age, in the 1960s, reduced the doubling time to about 5 years. And, with the Internet, the amount of information to which we are exposed currently doubles in less than a year.
Researchers now estimate that humans, with what we currently use of our brain potential, can only take in 12% of the visual information available. And for traders and investors the situation is at an extreme. A trader or investor, looking at every market in the world simultaneously, could easily have about a million bits of information coming at him or her every second. Since there are usually some markets open around the world at all times, the information flow does not stop. Some poor traders actually stay glued to their trading screens, trying to process as much information as possible for as long as their brain will permit.
The conscious mind has a limited capacity to process, about 7 (plus or minus 2) chunks of information at a time under ideal conditions. A “chunk” of information could be one bit or it could be thousands of bits (for example, a chunk could be the number 0 or a number like 7,941). Read the following list of numbers, look away, and then try to write them all down.
34 39 85 93 21 98 43 56 76 53
You probably couldn’t do it because we can only consciously process 7 (plus or minus 2) chunks of information at one time. Yet we have millions of bits of information coming at us every second. And with the current rate of information availability doubling every year, how do we cope?
The answer is that we generalize, delete, and distort the information to which we are exposed. We generalize and delete most of the information. For example, “Oh, I’m not interested in the stock market.” That one sentence takes about 90% of the information available on the markets, generalizes it as “stock market information,” and then deletes it from consideration.
Psychologists have taken a lot of these deletions and distortions and grouped them together under the label “judgmental heuristics.” They are called “judgmental” because they affect our decision making process. They are called “heuristics” because they allow us to shift through and sort out a lot of information in a short period of time. Heuristics are shortcuts! We could never make market decisions without them, but they are also very dangerous to people who are not aware that they exist. They affect the way we develop trading systems and make investment decisions.
The primary way most people use judgmental heuristics is to preserve the status quo. We typically trade our beliefs about the market and once we’ve made up our minds about those beliefs, we’re not likely to change them. And when we play the markets, we assume that we are considering all of the available information. Instead, we may have already eliminated the most useful information available by our selective perception.
Interestingly enough, William Eckhardt points out in his chapter of The New Market Wizards that progress in knowledge results more from efforts to find fault with our theories, rather than prove them.1 If his concept is true, then the more we tend to realize our beliefs and assumptions (especially about the market) and disprove them, the more success we are likely to have making money in the market.
Thus, what are the beliefs and theories that need to be disproved for us to make progress? These beliefs represent many of the biases that we must overcome in order to make progress. My journey as a trading coach and as a modeler has certainly involved a lot of disproving the status quo.
The secret to success is in understanding how these biases affect you, and then turning yourself into an effective investor/trader. If you try to project what you learn outside of yourself onto the market, you will not be able to apply any of the principles taught in this book. Money is made through the personal application of these principles.
1. Schwager, Jack, and William Eckhardt. New Market Wizards. Harper Collins, 1992.