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It is embedded in our psychology as humans to desire more – more love, more wealth, more money, more fame etc. Most of these factors that we desire to increase enhance our health, mind set and most importantly, our social status. For many people being rich equals financial freedom, i.e. the idea of you have enough money so you can do whatever you want without having a 9 to 5 job that is soul crushing. Consequently, most of us look for ways of earning extra income. A vast majority of people turn to trading – buying and selling stocks based on mathematical predictions of market movements in short-term. However, this strategy to make money is flawed for a number of reasons that are rooted in our psychology as humans and in our ability to understand, predict and interact with the future.
Randomness
The Lebanese-American statistician, risk analyst and trader, Nassim Nicholas Taleb in his book Fooled by Randomness: The hidden role of chance in life and in markets discusses the role of randomness (chance) in our interaction with the financial markets. The very nature of the trading profession is based on betting on market movements. Therefore, the frequency and probability of loss or gain are irrelevant: what matters is the magnitude of the outcome. In other words, the expectation (probability x outcome) is what traders should consider and not the probability alone. Another misunderstanding that relates to chance is that we usually attribute success to our skills and we might think that it is the right thing to do and feel: after all, we work hard to understand financial concepts and to calculate the possible stock movements. However, external factors that range from massive geo-political events to anything as obscure as the randomness of human actions and feelings can and do influence the results of your trades. Such events, which are most often than not rare, are known to wipe out huge amounts of money virtually overnight.
The beauty of randomness or chance need not be feared but embraced. Successful traders, such as George Soros, understand that reality is a web of random events and you need to develop your own mechanisms of defence against them.
Psychological barriers
We are all prone to psychological biases. However, trading, as investing, are two professions in which temper and psychological training are more important than IQ. Professor Robert Cialdini in his book Influence: The Science of Persuasion talks about these biases. For example, we are prone to do, think or want something even more if others with which we associate are doing, thinking or wanting that thing – it is called the social proof bias. In the business world, Warren Buffett calls it the institutional imperative: CEOs, investors and traders are imitating what others are doing regardless of whether it makes business sense or not. This is at the basis of financial crisis, insider trading cases and market manipulation probes!
Moreover, we, as people that deal with chance on a daily basis need to be aware of our thoughts and feelings: know yourself in order to react in the most efficient manner to market movements. Logic and reason should be the basis of your decisions. However, do not ignore your feelings: remember the times you are successful – that rush that goes through your body caused by adrenaline and never let it fool you that because it happened in the past it will happen again.
Finally, emotions are tools. As traders, we need to learn that each situation needs to be met with the right type of emotion. Charles Munger, one of the most successful businessmen and investors of all times, chairman of Berkshire Hathaway, in a speech about human psychology talks about the ‘man with the hammer’ syndrome. It goes something along these lines: to a man with a hammer every problem looks like a nail – in other words, for someone used to do and see things in a certain way, adopting to change is very difficult. Therefore, traders need to be aware of this psychological barrier and simply by knowing about it, you can overcome it.
Technological barriers
Finally, my favourite barrier – artificial intelligence algorithms. In the book called simply Flash Boys: A Wall Street Revolt, author Michael Lewis focuses on the rise of high-frequency trading in the US equity market. High-frequency trading (HFT) is a fascinating thing really: it is an automated trading platform used by large investment banks, hedge funds and institutional investors which utilizes powerful computers to transact a large number of orders at extremely high speeds. It uses powerful computers to transact a large number of orders at very fast speeds and uses complex algorithms to analyse multiple markets and execute orders based on market conditions. Those that trade the fastest make the most profit. The danger is obvious: spiked market volatility that led to numerous temporary crashes of stock exchanges. For example, the Flash Crash of May 6, 2010 was the result of HFT: stock indexes in the US collapsed and bounced back very rapidly. Those that use HTF need to never forget that if you damage the fabric of the financial markets no one, not even you, will make a profit. Therefore, the use of HTF should be highly regulated and monitored.
Such algorithms beat any trader with a human mind. However, traders do not let yourselves discouraged. Machines are built by people. Therefore, one way to overcome them is to use what they do not have: consciousness – you see, algorithms are programmed and learn from a numerical pattern. They are able to assess mathematically the behaviour of markets but not the emotions behind them – we can: be greedy when others are fearful and be fearful when others are greedy.
The alternative – investment
John C. Bogle in his book The Clash of the Cultures: Investment vs. Speculation, underlines that investment is equivalent to capital allocation. Both investment and trading implies making bets on future prospects. The difference is that as an investor you are an owner of the business, you [should] get directly involved in the management of the business and you [should] do qualitative research along the lines of Philip A. Fisher in Common Stocks and Uncommon Profits. Successful investors identify companies that can resist the mean reversion (something that markets as financial creatures cannot for they are themselves the one that revert to the mean) by buying businesses with solid competitive advantages. This is one of the reasons why investors have a longer track record of ‘beating the market’ than traders.
Therefore, before consider trading, do prepare yourself to deal with randomness, your psychological structure, A.I. algorithms that beat any human mind and market movements that are unpredictable in short-term.
