Is So Difficult for Most People

We typically trade our beliefs about the market and once we've made up our minds about those beliefs, we're not likely to change them. And when we play the markets, we assume that we are considering all of the available information. Instead, our beliefs, through selective perception, may have eliminated the most useful information.

You now understand that the search for the Holy Grail system is an internal search. This chapter will help you in that search by learning about what might be holding you back. It is your first step: becoming aware of what holds you back. When you have such awareness, you also have the ability to change.

Overall, a basic source of problems for all of us is coping with the vast amount of information we must process regularly. French Economist George Anderla has measured changes in the rate of information flow with which we human beings must cope. He concluded that information flow doubled in the 1,500 years between the time of Jesus and Leonardo DaVinci. It doubled again by the year 1750 (i.e., in about 250 years). The next doubling only took about 150 years to the turn of the century. The onset of the computer age reduced the doubling time to about 5 years. And, with today's computers offering electronic bulletin boards, CD ROMs, fiber optics, the Internet, etc., the amount of information to which we are exposed currently doubles in about a year.

Researchers now estimate that humans, with what we currently use of our brain potential, can only take in 1 to 2 percent of the visual information available at any one time. And for traders and investors the situation is at an extreme. A trader or investor, looking at every market in the world simultaneously, could easily have about a million bits of information coming at him or her every second. And since there are usually some markets open around the world at all times, the information flow does not stop. Some misguided traders actually stay glued to their trading screens, trying to process as much information as possible for as long as their brain will permit.

The conscious mind has a limited capacity to process information. Even under ideal conditions, that limited capacity is between 5 and 9 chunks of information at a time. A "chunk" of information could be 1 bit or it could be thousands of bits (for instance, a chunk could be the number 2 or a number like 687,941). For example, read the following list of numbers, close the book, and then try to write them all down:

Could you remember all the numbers? Probably not, because we can only consciously process 7 plus or minus 2 chunks of information. Yet we have millions of bits of information coming at us every second. And the current rate of information availability is now doubling every year. How do we cope?

The answer is that we generalize, delete, and distort the information to which we are exposed. We generalize and delete most of the information-"Oh, I'm not interested in the stock market." That one sentence takes about 90 percent of the information available on the markets, generalizes it as "stock market information," and then deletes it from consideration.

We also generalize the information we do pay attention to by deciding, "I'm only going to look at the daily bar charts on markets that meet the following criteria.. ." We then have our computers sort the data according to those criteria so that an incredible amount of information is suddenly reduced to several lines on a computer screen. Those few lines are something we can process in our conscious minds.

Most traders and investors then distort the generalized information that remains by representing it as an indicator. For example, we don't just look at the last bar. Instead, we think the information is much more meaningful in the form of a 10-day exponential moving average, or a 14-day RSI, or a stochastic, etc. All these indicators are examples of distortions. And what people trade are "their beliefs about the distortion "-which may or may not be useful beliefs.

Psychologists have taken a lot of these deletions and distortions and grouped them together under the label "judgmental heuristics." They are called "judgmental" because they affect our decision-making process. They are called "heuristics" because they allow us to sift through and sort out a lot of information in a short period of time. We could never make market decisions without them, but they are also very dangerous to people who are not aware that they exist. They affect the way we develop trading systems and make decisions about the market.

The primary way most people use judgmental heuristics is to preserve the status quo. We typically trade our beliefs about the market, and once we've made up our minds about those beliefs, we're not likely to change them. And when we play the markets, we assume that we are considering all the available information. Instead, we may have already eliminated the most useful information by our selective perception.

Interestingly enough, Karl Popper points out that progress in knowledge results more from efforts to find fault with our theo ries, rather than prove them.' If his concept is true, then the more we tend to realize our beliefs and assumptions (especially about the market) and disprove them, the more success we are likely to have making money in the market.

The purpose of this chapter is to explore how such judgmental heuristics or biases affect the process of trading or invest ing. First, we'll cover biases that distort the process of system development. Most of the biases covered fall into this category. However, some of them affect other aspects of trading as well. For example, the gambler's fallacy affects trading system development because people want systems that don't have long losing streaks, but it also affects how the system is traded once it is developed.

Next, we'll cover biases that affect how you test trading systems. For example, one gentleman, when exposed to some of this information, claimed that it is full of controversy and that key elements were left out. Those statements, however, were just projections coming from him. There is no conflict within the material presented in this book-it's just information. Thus, if you perceive such controversy, it is because that controversy is commg from you. In addition, some steps that most people do in system development are left out, but they are left out intentionally because my research shows that they are not important or are more of a hindrance (than a help) to the development of a good system.

Lastly, we cover a few biases that might affect how you trade the system you've developed. Although this is a book about doing trading system research, the biases included here are important because you need to consider them when you are doing your research-before you actually start trading. I've deliberately kept this part of the chapter to a minimum, however, because these biases are covered in much more detail in my home-study course for traders and investors.

BIASES THAT AFFECT TRADING SYSTEM DEVELOPMENT

Before you think about trading systems, you have to represent market information in a way that your brain can cope with the available information. Look at the chart in Figure 2-1. It illustrates a typical bar chart-which is how most of you think about the market. A daily bar chart, as shown in the illustration, takes a day's worth of data and summarizes it. That summary includes, at most, four pieces of information-the open, the close, the high, and the low. Japanese candlesticks make the information a little more obvious

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Figure 2-i A simple bar chart and also give you visual information about whether the market generally moved up or down.

That daily bar chart is a good example of the first heuristic, which everyone uses, called the "law of representation." What it means is that people assume that when something is supposed to represent something, it really is what it is supposed to represent. Thus, most of us just look at the daily bar and accept that it represents a day's worth of trading. In reality, it's just a line on a piece of paper-no more and no less. Yet you probably have accepted that it is meaningful because:

. You were told it was meaningful when you first started studying the markets.

* Everybody else uses daily bars to represent the markets.

* When you purchase data, the data are typically in daily bar format.

* When you think about a day's worth of trading, you typically picture a daily bar.

Representation Bias

Each bar on the chart in Figure 2-1 only shows you two things. It shows the range of prices that occurred throughout the day. And it says a little bit about how prices moved-they moved from the open to the close (plus some variation for the high and the low).

What doesn't a typical daily bar show you? A daily bar doesn't show you how much activity occurred. It doesn't show you how much activity occurred at what price. It doesn't show you when during the day the underlying commodity or equity was at a given price (except at the beginning or the end). Yet this information might be useful to traders or investors. You can get some of this information by lowering your time frame and looking at 5-minute bars or tick charts. But wait! Wasn't the purpose of the daily bar chart to reduce the information flow so you are not overwhelmed?

There is a lot of other information that might be useful to traders that is not shown in the daily bar chart. In the case of futures, did the transactions involve opening up new contracts or closing out old ones? What kind of people were doing the trading? Did a handful of floor traders trade with each other all day long-trying to outguess and outmaneuver each other? How much of the activity was in the form of a single unit (100 shares of stock or a single commodity contract)? How much of the activity was in large units? How much was bought or sold by large investors ? And how much was bought or sold by large money managers or portfolio managers? How much was bought or sold by hedgers or big companies?

And there is a third class of information that is not represented in the daily bar chart-who's in the market. For example, how many people are currently holding long or short positions? What is the size of their positions? That information is available, but it is generally not easily accessible. The various exchanges, with the kind of computers there are today, could store and report information like this each day:

The price moved from 83 to 85. There are 4,718 investors holding long positions, and the average position size is 200 units. During the day, long positions increased by a total of 50,600 units. There are 298 investors holding short positions with an average position size of 450 units. Short positions increased by 5 units. The top 100 positions are held by the following people, and their position is., [followed by a listing].

Perhaps, you're saying, "Yes, I'd like to know who owns what and how large their positions are." Well, if you had that information, would you know what to do with it? Would it be any more meaningful? Probably not-unless you have some beliefs that would allow you to trade it.

The daily bar chart also does not give you any statistical prob-abilities-given that X happens, what is the likelihood of Y? You can use historical data to determine the likelihood of Y, but only if variable X (and Y, for that matter) is contained in your data. But what if X or Y is interesting and not contained in your data?

Finally, there is another, critical type of information that is not included in a simple daily bar-psychological information about people's beliefs and emotions. That information involves the strength of conviction of the long positions and the short positions. When would various traders be likely to liquidate and at what price? HowT'Fyw-".À .A' will they react to various news items or ; -price movements? And how many peo- . ^at a #jiy bar, which is at-best sum-man»' irrfurmation,is f|^ically tliefaw _ ;. thatyoumanip-illatp ;

pie are sitting outside of the markets with the belief that it is going up or the belief that it is going down? Are they likely to convert those beliefs into market positions and under what conditions? And if they did, at what price and A.: how much money are they likely to ~

have to back their positions? But do you have beliefs that would help you make money from this information?

Until now, you've probably thought that a daily bar chart really was the market. Remember, all you're really looking at is a single line on your computer or chart book. You are assuming that it represents the market. You might call it a generalization about the market's activity on a given day, but that is the best you can call it. The scary thing is that a daily bar, which is at best summary information, is typically the raw data that you manipulate to make your decisions.

I hope that you're beginning to understand why judgmental heuristics are so important to you as a trader. Yet all I've given you is one example of one heuristic-the tendency we have to assume that a bar chart really represents a day's worth of market activity.

You could just trade bar charts. But most people want to do something with their data before they trade, so they use indicators. Unfortunately, people do the same thing with market indicators. They assume they are reality, rather than attempts to represent something that might occur. RSI, stochastics, moving averages, MACD, etc., all seem to take on a reality, and people forget they are just distortions of raw data that are assumed to represent something.

For example, think about the technical concept of support levels on a chart. Originally, technicians observed that once prices dropped to a certain area on the chart, they seemed to bounce back. That area was then assumed to be a level at which a lot of buyers were willing to buy and thus "support" the price of the stock. Unfortunately, many people treat words like "support level" and "resistance" as if they were real phenomena rather than simply concepts that represent relationships that people have observed in the past.

I've previously talked about the representation bias in the sense that people tend to judge something by what it "looks like" as opposed to what its probability rate is. This is especially important in terms of using a trading system or trading signal. Have you considered probability rate information in developing your trading system or assessing the validity of your signals? That is, do you consider the percentage of time that your predicted outcome follows your signal? Probably not, because I don't know one trader in 1,000 who does that-even though I tell people about it constantly. What this means is that most people don't even test their systems or know the expectancy of their systems (see Chapter 6).

Now let's discuss a few more biases. We'll determine what these additional biases might do to your thinking about the markets and to your trading system development.

Reliability Bias

A related bias to the representation bias is to assume our data are reliable-that they really are what they are supposed to be. With respect to the daily bar chart, we just commonly assume that it represents a day's worth of data. It looks like~a day's worth of data so that's what it must be. However, many data vendors combine day

TABLE 2-1

A Personal Story from (Shuck Branscomb

1 trade a portfolio of 16 futures markets using a system of my design. ] use portfolio trading system software to run my system code against daily data lo generate orders each nigh,. The basic entry/exit rules are programmed into a real-time sofbvare program so that I am alerted whenever I have taken a position in a market.

'On July 10, 1995 I had correctly placed all of my entry and exit orders for fhe podfolio prior to the open. Shortly after the Chicago currency markets opened, the real-time software alerted me to a long entry In the Canadian dollar. I was shocked since I hadn't even generated an order for the Canadian dollar that day. I just stared a, the screen for a few seconds in disbelief. Having mentally rehearsed being shocked by an unexpected market occurrence, I automatically fell into my rehearsal scenario: take a deep breath, relax all my muscles from forehead to toe while exhaling, and create a systematic process of checking for errors from highest to lowest probability.

"It took just a couple of minutes to find that the low for the previous day was different between the data I had downloaded for my portfolio soflware to run against versus that collected by my real-time software A quick check of the previous day's tickdata confirmed my suspicion: the data the portfolio system used was invalid, quickly edited the database manually and reran the program. It now generated an entry order. I glanced at the screen to see that the market had now rallied well above my entry point. I had feelings of frustration running through me. but I calmly inputted the information from the program into my portfolio manager spreadsheet to size the position. Looking at the screen, I saw the market up yet another 5 ticks now that I had the order ready. My reaction at that point was totally automatic and focused: called my trade desk and placed an order to enter the position at the market.

'This whole process consumed about 10 minutes time during which the Canadian dollar rallied further and further away from my Intended entry price. Fortunately, mental rehearsal saved me from second guessing what to do. My trading objectives include not ever missing a trade entry since I have no idea when a monster mo/e may be evolving. Missing out on a substantial winning trade is far worse than simply taking a small loss. When knew I should be in that market already, the phone call was an automatic, focused response. For the type of trading that I do, it was the right thing lo do. I have no use for hoping the market Will come back to the entry point or second guessing whether to follow through on the entry

7his occurrence marked the need for me to create a procedure that would force a disciplined checking of daily data for each futures contract. Up to that point, I thought that I did a sufficient job of screening dally data. I had caught many errors In the past, but I now knew that I needed to create ye, more work for myself each day to ensure that I can trade my business plan as designed.'

■ee: Market Mastery, July 1996, vol. 1(2): pp. 2-3.

data and night data, so is it really a day's worth of data? And what about the accuracy of the data?

Seasoned traders and investors know that data reliability is one of the worst problems that traders can have. Most data vendors are fairly accurate with respect to daily bar charts, but when you start using tick data, 5-minute bars, 30.minute bars, etc., accuracy goes out the window. Thus, if you are testing a system based on 5-minute bars, most of your results (good or bad) could have to do with innc-curate data rather than real expected results.

Look at the stoiy in Table 2-1 about the problems one can have with data. It's a personal story from editor Chuck Branscomb that appeared in one of our newsletters.

Now that you've read the story, you can understand how most people accept a lot more about the market than is true. All is not as one would expect. And when you think you have a good system, you could simply have poor data. Conversely, you might think that you have a bad system when what you really have are poor data.

But let's assume that you are accepting the fact that daily bar charts really do represent the market. You wish to accept that generalization and trade it. That's fine, but let me show you how many more biases probably creep into your thinking.

Lotto Bias

The lotto bias relates to the increased confidence people have when they, in some way, manipulate data-as if manipulating the data is somehow meaningful and gives them control over the market. Now that you've accepted the daily bar chart as your way of representing the market, you must either trade daily bars or manipulate them in some way until you feel confident enough to trade them. But of course the data manipulation itself often can and will give you this increased confidence.

A perfect example of how this illusion of control works is the state-run lottery game called lotto. When you play lotto, you get to pick some numbers (usually six or seven of them), and if you happen to hit all of them, you become an instant millionaire. People really like to play the lotto game (even logical people who understand the odds). Why? Because the prize is so big and the risk is so small (a dollar ticket is small compared with the size of the prize)

that people are drawn to play. It doesn't matter to them that the odds are so stacked against them that if they bought a million tickets (each with different numbers) they still would not be likely to win. Your chance of winning a million dollars in a state-run lottery is about 1 in 13 million (and the odds are much greater if you expect to win more).

The big prize for such a small amount of money is also a heuristic, but it's not the lotto bias. The lotto bias is the illusion of control that people get when they play the game. People think that because they get to pick the numbers that their odds of success are somehow improved. Thus, some people might suspect that if they picked the numbers in their birthday and their anniversary, it might improve their chances for winning. For example, about 10 years ago a man won the jackpot in the Spanish national lottery, He won it because of his interpretation of his dream. It seems that he dreamt about the number 7 for 7 straight nights. Since he thought that 7 times 7 was 48, he selected a ticket with the numbers 4 and 8 on it.

Others, rather than using their dreams, consult with psychics or astrologers. In fact, you can purchase all sorts of advice to help you win the lotto. Some people, who have analyzed the numbers thinking they can predict subsequent numbers, are quite willing to Sell you their advice. Others have their own lotto machines and believe that if they generate a random sequence of numbers, it ■.might just correspond to what the state-controlled lotto machine might select. They are also willing to sell you advice. And if some guru or astrologer claims to have several jackpot winners (a distinct possibility if the person has enough followers), then many more people will be attracted to that person. People will do anything to find the magic numbers.

If this seems a little familiar, it should be. This is exactly what occurs in speculative markets. People believe they can make a quick dollar by picking the right numbers. Picking the right numbers, in the case of speculators and investors, means that they sim-Ply want to know what to buy and when. The most important question the average person wants to know is what should I buy right ifcow that will make me a fortune. Most people would rather have 'Someone tell them what to do.

* People do everything they possibly can to figure out what to do right now. They buy software that picks numbers and analyzes tendencies. Brokers have found that if they help people pick numbers, by reading off entry points on radio and televisions shows, thousands of people will want their advice. If you are known to publicly give advice, no matter how accurate (or inaccurate) that advice is, people will consider you an expert. In addition, there are plenty of gurus who are good at promoting and are more than happy to tell people in their newsletters what to buy and when. And, of course, astrologers and fortune-tellers also play a role in this process.

Some people get the notion that perhaps they would be better off on their own. Consequently, they become fascinated by entry signals that they perceive to be synonymous with a complete trading system. You get a sense of control with entiy signals because the point at which you choose to enter the market is the point at which the market is doing exactly what you want it to do. As a result, you feel like you have some control, not just over your entry, but over the market. Unfortunately, once you are in a position in the market, the market is going to do whatever it wants to do-you no longer have any control over anything except your exits.

I'm amazed at what people consider a trading system! For example, one gentleman visited me from Australia several years ago. He'd been talking with various experts all over the United States about what kind of trading systems work. At dinner one night, he told me what he'd learned and showed me the "guts" of the various systems he'd discovered so that I could give him my blessing He had some great ideas. Yet all of his trading systems, as he relayed them to me, had to do with entry techniques. In fact, the only thing he described about each trading system was the entry. My comment was that he was on the right track, but if he'd now spend at least as much time working on his exits and position sizing, then he'd really have a good system.

Most people believe that they have a trading system if they have some sort of entry point that makes them money. As you'll learn later in this book, there are as many as 10 components to a professional trading system and the entry signal is probably the least important. Nevertheless, most people just want to know about entry.

i was a speaker at an international conference on technical analysis of futures and stocks in Malaysia in 1995. There were about 15 speakers from the United States, and we got rated on our performance. The speakers with the highest ratings talked mostly about entry signals. And the one speaker I heard who talked about the various components of a trading system, and gave a very valuable talk, received much lower rankings.

I attended one of the more highly rated talks. The speaker was a brilliant trader who was up about 76 percent in his account in 1994 with only a 10 percent drawdown. Yet what he talked about were mostly signals for picking changes in a trend. He presented six to eight such signals in his talk and mentioned something about exits and money management when people asked him. Later, I asked him if he traded all those signals. His response was, "Of course not! I trade a trend-following signal. But this is what people want to hear, so I give it to them."

One of my clients, upon reading this, made the following observation:

I have always felt that this "lotto" bias is a way of dealing with the anxiety of not feeling in control. Most people would rather pretend to be in control (and be wrong) than fear the anxiety of having no control over the environment in which they must exist. The big step is in realizing that "I have control over my actions." And that is enough!

This bias is so powerful that people frequently do not get the information they need to get to prosper in the market. Instead, they get what they want to hear. After all, people typically make the most money giving people what they want rather than giving them what they need. This book is an exception to that rule. And, I hope, there will be a number of such exceptions in the future.

Bias of the Law of Small Numbers

The pattern shown in Figure 2-2 could represent another bias for Some people. There are 4 days in which the market does nothing {within the first 5 days shown), followed by a big rise. If you peruse 80me chart books, you might find four or five examples like that, ■the law of small numbers says that it doesn't take many such cases for you to jump to a conclusion. For example, let's enter the market "Vvhen we have 4 days in a narrow range followed by a big jump in prices.

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