Plan for the outlier

Posted by By at 1 April, at 16 : 40 PM Print

TGR15_CoreEntrepreneurPreparing for bad times as well as good will make you a better trader, writes Louise Bedford.

All traders dream of buying something at $0.10 and having it go to $50. Unfortunately most do not consider the reverse – buying something at $50 and having it go to $0.10. Yet precisely this situation arose during the meltdown in the Global Financial Crisis that we are finally emerging from. This was an outlier. It’s a sequence of events so extreme that no one had considered it.

The interesting thing about such events is not the size of them but rather that no one had a plan of any note. I will accept the argument that this was an extreme event, but there were no plans at all within organisations such as banks and fund managers to deal with the collapse in asset values they experienced. What response they did have was somewhat akin to an ostrich sticking its head in the sand and squawking, “I can’t see you.” The only response that regulatory authorities had was to ban short selling which only made matters worse. Once this had occurred I was surprised that these geniuses didn’t go all the way and simply ban selling all together.

The interesting thing about trading is that the psychological problems of bedevil traders are universal, in that they also affect all individuals involved in complex or stressful decision making. Using the example of bushfires, Dr Mary Omedie of La Trobe University has done some interesting work in the area of decision making by firefighters. In her simulations she has found that once firefighters commit resources to a given fire they are very reluctant to remove these resources to deal with a secondary threat. They are emotionally anchored in their decision and are therefore reluctant to change their strategy. This is precisely the same issue that traders face when things begin to go wrong with a given trade. We are emotionally as well as financially invested so we struggle to alter our strategy.

This situation gets worse when events begin to unfold in an entirely unexpected way. Dr Omedie makes the following salient point when looking at decision making among firefighters: “We’re sort of very much thinkers of the present. We’re hard-wired to sort of think things will keep changing the way they’ve been changing up to that point.”

Consider this quote within the context of trading.

Traders make the assumption that tomorrow will be the same as today and therefore any planning that is undertaken reflects this very basic perception. There is no account taken of the fact that not only will tomorrow be different to today but that it may be so different as to be almost unrecognisable. We perceive that change occurs at a constant rate, or at least has a constant theme, and we plan around this constancy. Unfortunately the world, and particularly the trading world, is not like that.

Dr Omedie continues, “To put it into more cognitive terms we grossly overestimate our mental capacity. We overestimate the amount of information we can deal with, we overestimate the rate at which we can process information.”

In other words we are not as smart as we think we are. Complex systems that are undergoing rapid variable change overwhelm us. So the question becomes, if we acknowledge that we suffer from these cognitive drawbacks, what can be done in a trading sense to deal with our shortcomings?…

Excerpted from an article originally published in the April/May 2014 issue of Think & Grow Rich Inc. magazine. If you are a subscriber to Think & Grow Rich Inc. magazine, you will receive this article in your April/May 2014 issue of TGR. If you are not a subscriber, click here to subscribe.  

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