Trading discipline:
Homo Sapiens was not designed for constant risk. Our fight-or-flight reflex works poorly, damaging us mentally and physically, if it is triggered constantly. This is not cultural; it is biological, in our hormones, in the way our neurons are wired. Monkeys get chased by jaguars, but not every hour.
Trading stocks requires constant accurate risk assessment. Making money = taking risks. So, we have to constantly think about what disaster could be imminent. We have to constantly ask ourselves, “what am I not seeing that could hurt me?” Every tree in the forest could be concealing a jaguar. Guaranteed, there are jaguars in some trees, and some stocks are going to zero.
Our emotional response to any threat, works for avoiding jaguars, but consistently does not work for investing. Emotions give us a totally inaccurate risk/reward balance.
Mistakes we all might make, because we are human:
1. Over-estimating our ability to predict the future. Linear extrapolation fails, because change usually happens on a curve (sine wave, bell-shaped, parabola, S-shaped, approaching a limit).
2. Forgetting tail risk.
3. Cherry Picking Fallacy: Ignoring facts that do not reinforce prior conclusions, and then never admitting mistakes.
4. An investing or trading style that does not fit our personality. I am not a day-trader. I can do swing-trading and LTB&H.
5. False choice = only considering 2 possible outcomes, when there are 3, or 30.
6. Bandwagon Fallacy: Believing things because “everyone knows that”. Once upon a time, everyone knew disease was caused by sin; the cure was bleeding and purging, or burning witches.
7. Hasty Generalization = claim based on too few data points. Special or spectacular cases, local or recent trends, given too much importance.
8. Causal fallacy: our brains seek patterns and certainty. But reality is often chaotic. So we invent patterns; we see causation when there is only correlation or chaos.
9. Sunk Cost Fallacy: the value of anything, is what the market says it is, not what you paid for it.
10. Magical Thinking. Things don’t happen because you want them to happen. You cannot control external reality with your thoughts, or rituals, or wearing magic amulets.
list of Cognitive Biases: en.wikipedia.org
list of Logical Fallacies: mindtools.com
examples: indeed.com
My solution:
1. Act on facts, not emotion. Don’t do anything because it “feels right.”
2. Constantly test my conclusions: backtest, read contrary opinions, review results, willingly admit mistakes.
3. Before doing anything, research and make a plan.
4. Follow the plan, unless my initial assumptions and facts have changed.
5. Do everything in increments. I will never pick the exact top or bottom, but I can often get the range.
6. Simple plans are idiot-proof, and I am sometimes an idiot. You too.
7. Remember that list of mistakes our brains are hard-wired to make.
8. Diversify, but not so much I cannot follow everything I own. 15 stocks and ETFs, in 5 industries, is about right for me. |
