Why Traders Fail
by: Colibri Trader
TRADING and decision making are closely related. What role does the rational decision making has in developing a successful trading strategy is explained in the following short essay. Any trader, who wants to be consistently successful, should try to understand the way rational decision making works and try to work on his/her psychology. There is no better indicator for winning than one’s ability to control emotions and take the most rational decision when the chances of winning surpass the losing ones. The term rationality refers to the decision-making process that is logically expected to lead to the optimal result, given an accurate assessment of the decision maker’s values and risk preferences. This means that all possible outcomes in a definite trading set-up should be considered before further action taken.
From here, we might make another conclusion and it is that longer-term time frames might be more suitable for traders who want to be successful, since there is more time for assessing all possible outcomes. The rational model is based on a set of assumptions that prescribe how a decision should be made rather than describing how a decision is made. In his Nobel Prize-winning work, Herber Simon suggested that individual judgement is bounded in its rationality and that we can better understand decision making by describing and explaining actual decisions, rather than by focusing solely on prescriptive decision analysis. Therefore, the key to successful trading lies within each one of us and in order to get most use of it, we must try to concentrate on the longer picture of trading.
TWO SCHOOLS OF THOUGHT
IF we examine further the field of decision making, we can identify two different parts: the study of prescriptive models and the study of descriptive models. Prescriptive decision scientists develop methods for making optimal decision. For example, they might suggest a mathematical model to help a decision maker act more rationally. By contrast, descriptive decision researchers consider how decisions are actually made.
Therefore, one of the most important parts of successful decision making in a trading (and any other environment), is understanding our own decision-making processes. This would help clarify where we are likely to make mistakes and therefore when better decision strategies are needed. Second, the optimal decision in a given situation often depends on the behaviour of others. Understanding how others will act or react to your behaviour is critical to making the right choice.
In this overcrowded financial universe, where financial advice abounds, it is necessary to think at least one step ahead of others. We might try to identify the herd view and from there make our rational decision. Alternatively, we might decide to follow the herd, instead of trying to “out-wise” it. Making the right decisions does not sound that difficult, but why do so many people fail to do that rightly? One reason is because there is plenty of good advice about making decisions, but most people are not following it. Why not? Because they don’t understand how they actually make decisions, they do not appreciate the need to improve their decision making. Indeed, some of the intuitions that lead us astray also undermine our willingness to implement good advice. An understanding of this fact is needed to motivate people to adopt better decision-making strategies and be successful at trading.
WHY WE “SATISFICE”
WHILE Simon’s bounded-rationality framework views individuals as attempting to make rational decisions, it acknowledges that they often lack important information that would help define the problem, the relevant criteria, and so on. Time and cost constraints limit the quantity and quality of available information. Furthermore, decision makers retain only a relatively small amount of information in their usable memory. Finally, intelligence limitations and perceptual errors constrain the ability of decision makers to accurately “calculate” the optimal choice from the universe of available alternatives.
Together, these limitations prevent traders from making the optimal decisions assumed by the rational model. The decisions that result typically overlook the full range of possible consequences. Traders will forgo the best solution in favour of one that is acceptable or reasonable. That is, we “satisfice”: rather than examining all possible alternatives, we simply search until we find a “satisfactory” solution that will “suffice” because it achieves an acceptable level of performance. That is one of the major reasons why the majority of traders fail in making the right decision in order to win.
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