In my last blog, I considered the process of becoming an expert. In this one, I want to consider the process of excellent decision-making. I am indebted to Ms Ana Wang (www.awanginvest.com) for the free e-book: Psychology of Intelligence Analysis by Richards J Heuer. (https://www.cia.gov/library/center-for-the-study-of-intelligence/csi-publications/books-and-monographs/psychology-of-intelligence-analysis/index.html)
It is also available from Amazon (http://www.amazon.com/Psychology-Intelligence-Analysis-Richards-Heuer/dp/0160590353)
It is by far the best book I have read on the subject. It was commissioned by the CIA and recently declassified. It’s not my intent to review the book here. What I want to do is to examine its application to trading.
Behavioural Finance has revealed the barriers we face to clear thinking. What it has not done is told us how to overcome the problem. Indeed, some of the advocates have made the point that mere awareness of the problem does not of itself prevent the errors.
I agree. But certainly awareness will at least reduce the incidence of the errors – if we adopt a decision-making process in tune with how our minds work. Heuer provides the best process I have seen to date. To understand the process, we need to understand how our mind works.
The theory I think is correct is how our minds work ‘Bounded Rationality’ first suggested by Herbert Simon (http://en.wikipedia.org/wiki/Bounded_rationality): our minds cannot cope with the sensory input from a complex world. To prevent being overwhelmed, our mind construct relatively simple mental models to make our decisions. The models determine what we take in as important, how we organise the material and how we process it. In turn the model depends on our belief system, values, experiences, education, etc.
Models are useful because they help us make sense of the world. But they have one major drawback: they can lead to myopia if we fail to update the model. As new and conflicting information comes in, we can either update the model or force the information into our current model. If we adopt the latter course, our model diverges too far from reality and ultimately fails to provide the outcomes we seek.
The question then becomes, how do we prevent a locked mental mindset i.e. how do we create an environment that allows us update the model despite the discomfort we may feel?
The first step is to accept the discomfort. When reality hits us we have only three options: we can accept it, change it or walk away from it. In the case of the model, we accept the model, review the information and change the model – not the information.
Let me give you an example of what I mean.
Let’s say your outcome is to become a successful trader, and so far the year-end results show that you still have to make a profit. You have a couple of obvious choices. You can deny the results, rationalize them or accept that something you are doing is causing the results. To succeed you need to identify the causal action and change it.
This brings me to the strength of Heuer’s book. He suggests an interesting approach and unique tools using both the left and right brain.
For the left brain, one tool he suggests is a decision matrix. This call for identifying the essential aspects of the question seeking the answer e.g. what is the one to three-day direction of the ES and then to identify the information relevant to the question. In a trading context, Heuer would argue that only two types of information are necessary:
- Information concerning the probability attributed to the aspects included in the analysis and
- Information concerning which aspects are most important and how they relate to one another.
What traders don’t need is:
- More information about the aspects included in the analysis. For example if you are using the RSI as an overbought and oversold indicator, you don’t need the stochastic and rate of change to tell you the same thing.
- Additional variables without taking into consideration the importance of the variables – more information does not lead to more accurate results.
If you think through these ideas, you may find a wealth of information.
Another tool he suggested was to use the concepts of ‘proven’, ‘unproven’, and ‘disproved’.
First we need to define for ourselves what we mean by the terms. For example rather than say/think that an Upthrust Pattern often leads to a change in trend (See Nature of Trends http://www.amazon.com/Nature-Trends-Strategies-Successful-Investing/dp/047082235X/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1210593601&sr=8-1),
we can use the words “ES showed an Upthrust Change in Trend Pattern. (Unproven). You then need to define what you need to see to make the pattern ‘Proven’ or ‘Disproved’.
Why should we do this? Because once we have labeled a piece of information, we will find it difficult to change its meaning within our mental model. By leaving the meaning open, we’ll find it easier to accept new information that conflicts with the initial assessment.
I recommend you study the book and apply its lessons. It has certainly led to new insights for me. Chief among them: I changed my analytical approach and I changed my matrix. I use the matrix to ensure that I trade what I see – rather than what I expect to see or want to see.
Changing the approach and thinking through how and what to change in the matrix took effort. But it was worth it. Today, I spotted an error in my thinking for my long gold and short AUDUSD positions; I covered both first thing this morning. It also led me to anticipate the correction to the Crude Oil and allowed me to plan my response in a way better than I previousy would have done.
It will do the same for you.