In a battle of man versus machine, who will win?
If you’re talking about trading, it will be the machine, hands down and today’s newsletter will tell you why.
You have probably heard a lot about the psychology of trading. Don’t tune out just yet. Today I’m going to take your hand and give you a pathway to a line thinking demonstrating how, from a pragmatic point of view, algorithms will make you a better human. Or, at least, a better trader.
When faced with a decision that tugs at our primal fears or desires our brains start to weeble and wobble. They begin the decision-making process based on that primitive drive rather than a well-thought-out course of action.
How many times have you seen a piece of chocolate cake when on a diet and you somehow justified why you should devour it? “It’s just one piece.” “I’ll start my diet tomorrow.” “I didn’t eat the cupcake yesterday so I can have the cake today.”
In their NY Times bestseller, Nudge, Dick Thaler and Cass Sunstein, define two types of people, Econs and Humans. They make the case that all humans should utilize systematic decision-making processes for their decisions. Their plea is not a story. It is a justification for systematic model-driven judgments based on empirical evidence. Cold. Hard. Empirical evidence.
Empirical evidence shows model-driven decision-making is far superior to “expert-driven opinion.” This has been well documented over the years. But don’t just take my word for it. Today I am going to prove it. Here is an experiment that drives home the point.
Look at the image above but before you scroll down and answer the question, “Which square is darker, A or B?”
If you’re human A will be darker than B. However, if you were a machine you would recognize they are the same.
Perception is not reality
If you had to make a decision based on the color of square A or B your decision could have been wrong based on your perception but correct if you’d used an algorithm.
“Experts are uniformly inferior to algorithms in every domain that has a significant degree of uncertainty or unpredictability, ranging from deciding winners in football games to predicting longevity of cancer patients. One has to accept financial markets are no exception to the rule.” Daniel Kahneman
In Daniel Kahneman’s book Thinking, Fast and Slow he explains that the human mind employs two distinctly different methods of thinking at the same time. When it comes to trading, these different ways of thinking often oppose each other, and ignorance of their existence can explain why humans are not good traders. Daniel Kahneman and Amos Tversky won the Nobel Prize for the “Prospect Theory” that uses cognitive psychology to study how people manage risk and uncertainty. Their findings are extremely important in financial economics and reveal the weaknesses us humans exhibit when making investment decisions or faced with a piece of chocolate cake.
Kahneman’s book refers to two types of thinking as System 1 and System 2. I call these two systems Brain #1 and Brain #2.
Brain #1 and Brain #2
Brain #1 is your fast, automatic, frequent, emotional, stereotypical, and subconscious thinking system. The one that tells you, “Its ok, go buy that cherry red Mustang convertible, you can afford it.” Brain # 2, on the other hand, is your slow, effortful, infrequent, logical, calculating, and conscious system. The one that realizes there is no way in hell you can afford the cherry red Mustang, you can hardly afford a Ford Fusion. No offense to anyone who has a Fusion but seriously, compared to a Mustang?
Brain #1 relies on intuition and assumptions – in the trading world, this is called discretionary trading. Whereas properly harnessed intuition can be a tremendous asset, improperly harnessed intuition, like an improperly harnessed horse, can gallop us into manure fields like:
Confirmation Bias – the tendency to search for or interpret information in a way that confirms your preconceptions, leading you to believe the drop-dead gorgeous blonde sitting in the corner nursing a gin and tonic is actually looking at you.
Band Wagon Effect – the psychological phenomenon in which people do something primarily because other people are doing it, regardless of their own beliefs, which they may ignore or override. This can be coined the lemming effect.
Then you have the biases that are particular to trading but are the responsibility of the system developer. These are the ones you need to watch out for when evaluating a service like Quantitrader (QiT) or any system you want to use. Two such biases are; look ahead bias and survivorship bias that I will not delve into here since they are discussed in depth on my website.
We are not in the driver’s seat
There are so many more biases influencing our decision making that it would be impossible to cover them all here. However, what I would like you to take away from this discussion is, although we like to think our conscious brain is sitting in the driver’s seat, it’s not.
Traders are humans
As humans, we are affected by biases. We have an illusion of control and that we can influence the outcome of events but this is only an illusion. It’s all smoke and mirrors.
The Good and Bad News
The good news is being biased is not fatal. However, it is an obstacle to your goal of trading successfully and consistently and becoming as rich as Richard Branson. The bad news is that you will never fully overcome your biases, as long as you stay human.
Kahneman, citing his own lack of progress in overcoming biases, doubts that we can. This gives all the more emphasis to using machines to make emotionally driven decisions like we do daily when trading.
So the next time a position does not move in an expected way, do what successful traders have enough discipline to do. Stick to your predefined rules. In other words, give Brain #2 the reins.
Two brains walked into a bar and only one came out. Which one?
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
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