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In the introduction to psychology and trading, we covered some basic psychological principles that every trader needs to know. Trading is as much a mental game as a fundamental or technical discipline. Millions of human minds are out in the market trying to figure out how to make money.

We’re going to diver deeper now into the psychology behind trading, and how you can identify bad thinking. To get started, let’s take a look at the below low-resolution image.

What do you see?

Blobs of color: gray, blue, white.

The image has structure. Maybe you see the inside of a room. A large room.

Take a guess. Jot down five things you may be looking at.

Now, what is it?

That’s right, this is the NYSE stock exchange, here in high resolution.

How many things did you guess correctly? Was your mind able to make out the computers, the people, the banner, the tickers, or the flag? My guess is you probably didn’t get more than the computers. You might have gotten lucky, having guessed that a room probably has people.

Let’s toss these two images together and look again. Now when you look at the low-resolution image, your mind adds in some of the detail you learned from the high-resolution image. The low-resolution image makes much more sense after you see the high-resolution version.

Every day our minds construct mental images of the world and how things work. But how accurate are the mental representations? If you looked at the low-resolution picture and saw something other than what was there — maybe a dog or a bridge or a planet — then you experienced the perils of low-resolution thinking.

When we don’t see a piece of the world in full detail, and when we make choices based on our low-resolution model of the world, we are said to have a distorted view.  

The Big 3 — Trading with a Bad Mental Model

Each day traders make big trades thinking they understand what is happening in the market. They have a low-resolution model of how trading works. Time to take a look at why.

Below are three scientifically-verified mental distortions. These cost you money and get in the way of your high-resolution understanding of the market.

  • Ambiguity effect
  • Availability cascade (social belief)
  • Hyperbolic discounting

Ambiguity effect

Our first mental distortion concerns how we think about uncertainty.

People have a tendency to avoid decisions that have a fair amount of ambiguity, and instead choose options where the outcome is better known. We avoid uncertainty and cluster around what is known and what we can know. Let’s check out a realistic example.

Investors have a tendency to overvalue predictable investments such as bonds, bank savings, CDs, and money market accounts, over unpredictable investments like stocks. Even when shown the higher overall returns of more risky assets, investors avoid uncertainty and invest in safe, low-return instruments.

Availability cascade

Our second mental distortion demonstrates how humans are swayed by group thinking.

People have a tendency to adopt a new idea if others in their social network are adopting the idea, regardless of whether the idea is accurate. This means that people have a need to fit in and to assume that an idea is good if enough people around them also think the idea is good.

A recent example of this was the rapid rise of Bitcoin (BTC) from April to December 2017. Enough people heard about Bitcoin and believed it was a once-in-a-lifetime investment with unlimited upside. When friends and friends of friends were buying, how could one say no?

Hyperbolic discounting

Our third mental distortion deals with how we value a reward in the future over one today.

In a nutshell, hyperbolic means that humans prefer smaller rewards today compared to larger rewards later. We value the present over the future. People aren’t good at accounting for the future in decision-making. Here’s an example.

Say I offer to give you the choice between $1,000 right now or $2,000 in a year. You choose the $1,000 and discount the extra $1,000 gained over the year. Now, to make it more interesting, say I offer you $1,000 in five years or $2,000 in six years. Here you choose $2,000 because both choices are in the future, though this is the same choice but from five years away in time.

 

Advanced Trading Psychology

These three mental distortions give us a small glimpse into just how bad our thinking might be. As astute traders, we need to cultivate a deeper understanding of ourselves, the market, and the principles that drive trades. Behavioral finance has shown that humans are full of low-resolution pictures of reality and that these bad ideas cost us money.

I want to leave you with a piece of ancient wisdom as you head back to the battle royal of trading.

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” Sun Tzu’s The Art of War.

Courtney Bower is originally from the midwest. He travels extensively, writing about today’s big ideas.