There are certain quirks in the way your mind works that can completely sabotage your trading efforts. In his book Thinking, Fast and Slow, author Daniel Kahneman 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 explains poor trading results.
Kahneman refers to these two types of thinking as System 1 and System 2. Wikipedia describes System 1 thinking as “fast, automatic, frequent, emotional, stereotypical, subconscious” and System 2 as “slow, effortful, infrequent, logical, calculating, conscious.”
In order for System 1 to act quickly, it relies on intuition and assumptions. In the trading world, this is a sure way to leave yourself exposed. Properly harnessed intuition can be a tremendous asset, but System 1 also runs the risk of falling victim to overconfidence, isolation, and creating evidence to support the case it wants to make.
“Many people are overconfident, prone to place too much faith in their intuitions.” – Kahneman
Overconfidence is a result of System 1’s intuition running unchecked. Kahneman explains that once a plausible answer comes to mind, overriding it can be extremely hard work. When people believe that a conclusion they have created is true, they are very likely to also believe any supporting arguments and ignore any contrary arguments.
We see this at work time and time again with traders who refuse to cut their losses. Even if their analysis is purely intuitive, many traders will refuse to acknowledge any evidence that it could be wrong. They will spend hours digging for supporting evidence, but completely ignore the contrary evidence staring them in the face.
With trading, we have to be disciplined enough to stick to our predefined rules, because the overconfidence of System 1 will work against us every time a position does not move the way we expect it to.
“Money-primed people become more independent than they would be without the associative trigger. They persevered almost twice as long in trying to solve a very difficult problem before they asked the experimenter for help, a crisp demonstration of increased self-reliance.” – Kahhneman
Kahneman introduces the concept of “priming,” where System 1 is far more likely to react in a certain way if it has recently experienced a similar thought. He uses the example that people primed with thoughts about money are often more likely to isolate themselves and refuse to ask for help.
Unfortunately, traders are constantly being primed with thoughts of money because that is the main topic of trading. Therefore, traders are very likely to fall into the trap of isolation without even realizing it. This will cause them to refuse to consider anyone else’s opinion on their approach and often ends in self-destruction.
Once again, we have to be disciplined enough to stick to our systems. Our System 1 thinking will cause us to slip into a pattern of isolation without us even realizing it. If we change our systems in isolation, System 1 isn’t going to acknowledge that we might have made a mistake. Sticking to our systems can help us stay true to ourselves. It can also help to force ourselves to discuss our work with our peers.
Adjusting the Story to the Evidence
“We have limited information about what happened on a day, and System 1 is adept at finding a coherent causal story that links the fragments of knowledge at its disposal.” – Kahneman
Kahneman illustrates this point by describing how newspaper headlines changed on the day that Saddam Hussein was captured. When the bond market was up early in the day, Hussein’s capture was reportedly the reason. Then, when the bond market was down later in the day, Hussein was the reason for that as well. This documents a clear case of creating the evidence to explain the story.
System 1 will find a way to use whatever evidence we have available to explain the events of a given market day. It is important to keep in mind that there will always be an explanation, but explanations aren’t always the causes of an outcome. This is why so many systems focus exclusively on price and derivatives of price. The news headlines are usually just distractions.
Dealing With System 1
System 1 operates on automatic reactions to events that it encounters. Therefore, it is extremely difficult for System 2 to step in and take control with its more rational, analytical nature. However, simply being aware of System 1 and how it might sabotage our trading can go a long way towards preventing it from doing just that.
Many of us have already built measures to prevent System 1 from interfering with our trading systems. If we remember why we installed those measures and can stick to them, we have a good chance at minimizing the power of System 1 errors.