ForexSpirit

Seven deadly sins
Seven ways to win
Seven holy paths to hell
And your trip begins

Seven downward slopes
Seven bloodied hopes
Seven are your burning fires,
Seven your desires…
Moonchild - Iron Maiden

If you were to step back and evaluate your ability as a trader, how do you think you would fare? Would you consider yourself to be better or worse than other traders?

Every now and then I remind myself that it is important to be critical of one’s own abilities. Reflection and introspection can help us to get a better understanding of where we are on our journey; that journey might be focused solely on our trading endeavors or maybe on our life in general.

Even when attempting this sort of evaluation I all too often find myself being blinded to the obvious and sometimes the not so obvious. My own mind and body, my physical being, has limitations. Being made aware of these limitations can help immeasurably in making giant leaps when it comes to having tangible results out of performing these self-evaluation exercises.

I was reminded of these behavioural blind spots this week when I read a very interesting article by James Montier of Dresdner Kleinwort Wasserstein entitled Seven Sins of Fund Management.

If you follow the link to this article and open it up the first thing you’ll probably do is balk at the length of the piece: 105 pages! To head any such thoughts off, I can say that the article is well worth reading, even if it is rather long. You’ll also quickly realise that it is frequently padded with blank pages between chapters, with the always helpful and paradoxical tagline on such pages being: This page is left blank intentionally.

I’m going to evaluate each of the seven sins listed in the article against my own trading approach to see what I can learn and potentially improve going forward.

Sin 1: Forecasting

The first sin is forecasting. There is now ample evidence to show that we are useless at forecasting. All too often we are over-optimistic and over-confident. The more we think of ourselves as an expert in the field that we are forecasting in the more easily we fall prey to these two traps.

I have been aware of this bias for a while. I know that I am never going to be able to predict the next tick movement. One of the underpinnings of my trading methodology is that price is purely random in the short term. My edge only becomes applicable in the long term, over weeks and months.

The self-test of overconfidence on page 12 of the article is well-worth taking. It is a very simple and easy test to take. There is a very good chance that your own results will surprise you.

Sin 2: The Illusion of Knowledge

Second on the sin list is our never ending search for information. In the realm of investing this is a symptom of believing that the markets are always efficient. If the markets are always efficient then the only way to beat the market and make money is to know something that the market doesn’t. Of course, if we are able to find out this unique information then it creates a little paradox as we are part of the market and therefore the market as a whole still knows everything!

This eternal quest for more information is often the path followed by traders looking to deal with uncertainty. Uncertainty about the present state of the market and uncertainty about the future.

Research shows that we do not make better decisions given more information. Once we have accumulated a certain amount of information (which tends to be very small), anything beyond that does not actually increase our accuracy. Instead it just increases our confidence.

Being more confident will not make you more money. Being more accurate will.

Since it is the first set of information that is critical in determining our accuracy it certainly seems to make sense to focusing on collecting ‘better’ information. It’s more important to have a small set of high quality information than a large amount of information (which will most likely include the high quality stuff, but also lots of information of less relevance).

The information I normally collect consists of the various economic data releases that I’m interested in along with articles and market reports from analysts whose opinion I value.

Knowing that having too much information is not going to help me make better decisions it is important for me to cast a critical eye over the information that I do collect to make sure that I really do value it.

Are the economic data reports I look at really worth knowing about? Which ones are really going to have an impact on the market and which ones just generate noise?

Similarly, it means that I have to keep a constant eye on the daily and weekly e-mails and reports that I read from various market experts. Are they adding to my wealth of knowledge or just a waste of time?

Be critical of the information that you use as input to your trading decisions. Cut out the fluff so that you can spend more time pondering on the core information.

Sin 3: Meeting Companies

While forex traders don’t have to deal with meeting the management boards of companies (a task that fund managers of stock portfolios must partake in), we do have to deal with the tricksters that reside in central banks around the world.

Interest rate policy statements and beige books are picked apart to glean information on the state of the economy. In the same way that James Mortier warns that we must be careful when interacting with the management of companies we might want to invest in, I think it is wise to keep in mind the same psychological hurdles when dealing with macro-economic information we receive from the governments and central banks.

As I highlighted in the previous sin, more information is not always more helpful. Pick the economic data and reports that you find of most value. Ignore the rest. Weekly US employment figures are there to suck in the news traders who go after every single piece of data released; to me it’s just noise and I ignore it.

The people who put together and release the economic data are just like you and me. They’re human and have the same flaws that we all do. They suffer from cognitive illusions and are going to be highly biased towards whatever agenda they are looking to fulfill. Take the current Fed’s stance on inflation. As everyone knows their top priority is to combat inflation. This focus is biasing how they interpret information they use to reach their interest rate decisions.

A third psychological hurdle to overcome is confirmatory bias. We have a habit of looking for information that already agrees with our point of view. Using the Fed as an example here, they are more likely to latch onto economic data that shows inflation is still a problem, rather than fairly balancing it with data showing the opposite, or data that highlights another issue (such as economic slowdown due to the housing market slump).

We also have a tendency to obey figures in authority. Ben Bernanke seems to have a prestigious background in economics and is the current head of the Federal Reserve. It seems to make sense that he might actually know what he’s taking about. Unfortunately, when it comes to economics and trading, things are far more of an art than pure science. Alan Greenspan is generally revered as a great economist and yet he was chairman of the Fed during two huge economic bubbles.

Lastly, how do we know if they’re telling the truth or not? We are far less likely to be able to tell if someone is telling a lie than we are generally led to believe. Let the facts speak for themselves and don’t be influenced by the person delivering the information.

Sin 4: Thinking You Can Out-Smart Everyone Else

To me this was probably the most interesting section of the article.

How far ahead are you thinking when it comes to making trading decisions? When you are evaluating the market situation how far ahead are you looking when it comes to how other market participants are going to react?

Think of it as if you were playing a game of chess. How many moves ahead are you looking at before you decide what to do now?

In trading terms this converts to: how well are you considering what the average opinion of the market is? It is the average opinion of the market that will decide whether prices go up or down. If the average opinion is that the market is going to go higher, then the bulls will be in charge. That is looking ahead one step.

Pretty much everyone is able to look ahead that one step and make a decision as to what the average opinion of the market is. All those people who think this one step ahead will use whatever conclusion they reach as an input to their decision making.

Let’s look inside the head of a trader who I’ll name Joe. Joe looks at the market one step ahead and determines that the average opinion of the market is bullish. If Joe’s trading method is to trade on corrections to the main trend then he might start looking for an opportunity to go short.

To get ahead of those people who are thinking only one step ahead you need to consider the average opinion of the average opinion. What is going to be the decision reached by those people who think about what the average opinion of the market is? Thinking such thoughts gets you ahead two steps.

To help you get your head around this two step look ahead let’s go back to looking at the thought process of Joe. In my first step look ahead Joe determined the average opinion of the market is bullish, but that he’s going to look for shorting opportunities as he likes to trade corrections. He’s therefore probably looking for a time when price seems to stall at a resistance level.

If he decides to look two steps ahead then he’ll be trying to determine what the majority of market participants are going to do with their new found knowledge that average opinion of the market is bullish. Joe’s reaction is to go short due to his correction based trading method. How many other traders are going to do the same thing? How many traders are going to ride the bullish trend versus how many are going to try to short it? Determining an answer to this question is completing the second look ahead step.

The majority of people will either stick to thinking ahead one or two steps. If you are able to push yourself and think ahead to a third step then you are generally able to have formulated a way of thinking that allows you to effectively think ahead an infinite number of steps. You are able to see the natural progression of where each step is taking you and reach a conclusion without having to actually iterate over every single step.

Being able to think ahead to that third step is a huge advantage when it comes to trading. In the test conducted by James Montier only 4% of the participants thought ahead to that third step. If 96% of people are only ever able to think ahead one or two steps then you are naturally going to be ahead of the game if you can think ahead to that third step.

It is generally stated that only 5% of people ever make money trading. I would not be surprised to find out that the 4% of people who are able to think three steps ahead are all amoungst that 5% of profitable traders.

Look to push your thinking and reasoning that extra step when you are analysing your trading data.

Sin 5: Short Time Horizons and Overtrading

Trading at too short a time frame and overtrading are both classic trading mistakes. Of course, one person’s short term horizon is another’s long term.

The current average holding period for a stock on the New York Stock Exchange is eleven months. For James Montier this length of time is far too short, and he views holding stocks for such a short period of time to be nothing more than speculating and not investing.

For the average retail forex trader eleven months is probably seen in their eyes as about as far away as the end of time. When you’re looking at one minute or five minute charts, eleven months is an eternity.

Even for me, looking at my two hour, four hour and daily charts, eleven months seems an awfully long time. It is the sort of time frame that I use when considering my one direction (i.e. the trend direction in which I will trade), but it is not the time frame that I think in on a day to day basis when making actual trades.

I also don’t obsess about my trading results over the short term. I like to record my monthly profit or loss on my past performance page, but even at the monthly granularity I’m not too concerned with positive or negative results. Quarterly or yearly results are what matter most to me.

Trying to determine whether a trader’s results are a product of their skill or just pure luck can be difficult at best. It is only over the very long-term that we have any chance of trying to reach a valid conclusion. It is primarily for this very reason that I am only concerned with my trading results over a long period of time.

Having positive results in the short term certainly helps with keeping my mental energy buoyed up.

Overtrading can be detrimental to your trading capital as you end up paying a lot in trading costs. Even though most retail forex brokers offer commission free trading, the spread you pay on entering and exiting any trade is money in your broker’s pocket.

Sin 6: Believing Everything You Read

Another natural tendency for people to follow is to construct stories given a certain set of information. We find it hard to objectively evaluate disparate pieces of information. We instinctively look to form a story out of the pieces of information that we have to hand. We then extrapolate and guess all the missing links in the story we have managed to construct so far.

Of course, the validity of the story we make up is highly dependent on what pieces of information we have. The accuracy of the leaps of deduction undertaken to fill in the gaps will flow directly from how true the overall story is.

I often talk about viewing the continual release of economic data reports as being small incremental advances in the plot of an overriding forex storyline. The initial storyline is setup based on the long term direction of the currency pair that I am interested in. The primary plot line is generally something along the lines of: the dollar is declining in value.

It therefore goes with saying that I’m guilty of building a story out of the economic information that I use in my decision making. Being made aware that this natural tendency to formulate stories can lead to biased thinking will make me more critical in future of how I view the overall story I use and how it’s plot changes based on economic data updates.

I often like to take a critical look at my storyline every-so-often to determine if it still holds up to more recent events. This is to counteract a previously mentioned cognitive bias whereby we normally only seek to reaffirm our currently held beliefs. It pays to look more closely at information which goes against our viewpoint to determine if it has validity.

As a trader you have learn how to lose. Similarly, you must also be able to readily admit when you have been wrong in your viewpoint. There is no shame or disgrace in admitting that you are wrong and changing your outlook.

Sin 7: Group Based Decisions

While it would seem to be common sense that groups make better decisions than an individual, thirty years of research have shown the exact opposite.

Instead of synergy occurring between all the people in the group, what happens is that the group amplifies the biases that exist instead of counteracting them! The group can be easily swayed by powerful figureheads and hidden or unknown information is rarely uncovered.

The closest analogy I can see to group dynamics that most retail forex traders encounter are internet discussion forums.

The vast majority of members on forex discussion forums are new traders looking for their holy grail. It can be very much a case of the blind leading the blind.

This is not to say that forums are totally harmful. They can be a great treasure trove of useful information and thoughtful discussion; you just need to be very picky about how you avail yourself of them. Don’t become addicted to constantly browsing forums.

If group decisions are not going to be of any help then it only makes sense that you stick to your own individual decision making process. This is another great reason why you have to learn how to trade on your own. You must put together your own trading plan and then follow it. You have to take responsibility for your own trading actions. If you shoulder the responsibility then you are more open to critiquing your methods and your decision making process. You are open to making improvements to every aspect of your life to hopefully move you closer to your goals.

It should probably go without saying then that following trading signals that you receive is not the way to go. Whether you pay a fee to receive exact entry and exit signals or just follow tips from your friends or people posting on message boards, you are placing your trading fate in the hands of others. You are eschewing the responsibility that you must shoulder to become the successful trader that you ultimately want to be.

Sin, sin, sin. We’re all sinners

It’s fascinating to read through this list of ’sins’ and the underlying cognitive biases and realise that I’ve committed them all many times over at many times in my life.

Of course, the goal now is to keep this information at the back of my mind so that I don’t fall for any of these traps again.