Thinking, Fast & Slow is a good book on behavioral science. It has broad applications for investors, traders, and trading psychology.
Here are some key concepts and how they apply to trading.
Snap judgements and heuristics
The human mind has a tendency to use shortcuts when making decisions and conclusions. 3 common shortcuts are:
- Confirmation bias
- Availability heuristic
The human mind often oversimplifies things when we don’t have sufficient information and data, which leads to errors.
You see this all the time. Debt is rising. Someone looks at a chart with rising debt and screams “debt bubble! Stocks will crash!”
On the surface, this makes sense. A simplistic argument goes like this
“Rising debt is bad for the economy and stocks because we are borrowing from the future! Sooner or later, we’ll have to pay back what we took from the future!”.
Reality is much more complicated. This is why Ray Dalio says that we need a “deep understanding” of things instead of surface-level generalizations and oversimplification:
- Rising debt on its own isn’t bad, if the debt is used to finance income-generating activities (e.g. a farmer buying a tractor).
- Rising debt becomes bad when the pace of rising debt is faster than the pace of income growth (i.e. rising debt outstrips income growth).
- Rising debt is bad is worse when it is concentrated in 1 part of the economy (e.g. banking sector) than when it is spread out across the economy.
Chart fractals are another form of oversimplification. Fractal traders often say “the market today looks just like e.g. 1999”.
That is a case of extreme oversimplification. Something as complicated as the stock market does not merely “copy” the chart of another era. But nevertheless, fractals remain popular among market watchers because they are simple and easy to understand. Not everyone has the time, ability, nor patience to truly study the market. But anyone can understand a chart with 2 lines on it. This is also why technical indicators are extremely popular (anyone can understand these), but aren’t often useful. (Click here to see the Technical Indicators Backtest)
When there is missing or insufficient information, our minds will often fill in the gaps, leading us to potentially wrong conclusions.
There isn’t a whole lot to say about confirmation bias because most people know about it already. But confirmation bias is something that people need to especially watch out for when using social media.
Social media – whether it be in finance or politics – is merely an echo chamber. E.g.
- If you are a liberal, all the tweets or Facebook posts that you’ll see will be about how silly conservative policies are. You will rarely see any constructive difference of opinion.
- If you are a conservative, all the tweets or Facebook posts that you’ll see will be about how silly liberal policies are. You will rarely see any constructive difference of opinion.
- If you are bullish, all the tweets that you’ll see on Twitter will be about why the market will go up Up UP.
- If you are bearish, all the tweets that you’ll see on Twitter will be about why the market will crash Crash CRASH.
*Twitter and Facebook’s algorithms rank tweets and posts based on how likely you are to be interested in them. In other words, they purposefully serve content to you that amplifies your confirmation bias. E.g. if you follow a liberal on twitter but you are a conservative, Twitter’s algorithm probably won’t show you the liberal’s tweet. Instead, the Twitter algorithm will fill your feed with popular tweets from conservatives laughing at liberals.
“Availability heuristic” means that you overestimate the probability of something you hear very often.
For example, the media constantly mentions “2008” (a year when the stock market crashed), but very rarely does it mention “2013” (a year when the stock market soared). Since you always hear about “2008” and rarely hear about “2013”, your mind greatly exxagerates the probability of a market crash and underestimates the probability of a big stock market rally.
This is what I mean when I say “everyone remembers 2008, but not many remember 2010, 2011, 2012, 2013….”
This is why traders and investors constantly blow the probability of a 1987-style crash out of proportion. Based on how often the media mentions “1987 crash”, you would think that a one day, 20% crash happens all the time. In reality, it has happened ONCE in more than 100 years. That is an extremely low probability event.
The author also mentions a concept called “base rate neglect”, which means that the human mind tends to forget that statistics will regress to the mean. Following a big deviation from the mean, the mind forgets that variations from the average will eventually revert.
For example, let’s assume that the stock market crashes 20% in 1 day. Following such a crash, most traders will be extremely fearful because they forget that such a crash is a big divergence from the mean. The market will eventually regress to the mean.
A small change in how a statistic is presented can change how people view the statistic. For example, compare the statements:
- There’s an 80% chance the stock market will rally.
- There’s a 20% chance the stock market will tank.
Immediately, the first statement sounds like good news while the second statement sounds like bad news, even though they are the same.
A similar concept is “denominator neglect”, which also makes the human mind overemphasize the probability of an unlikely event. Consider the 2 statements:
- When XYZ happened (historically), the market crashed 5% of the time.
- When XYZ happened (historically), 1 in 20 of these events resulted in a stock market crash.
Immediately, the second statement sounds worse than the first statement.
- For the first statement, you’ll think “it’s only a 5% probability – that’s unlikely”.
- For the second statement, you’ll think “what if this is one of those 1 in 20 cases?”
In a way, this demonstrates loss aversion. The human mind is more afraid of loss than gains. Studies have repeatedly shown this.
When asked to flip a coin that has a 50% chance of earning $1100 and a 50% chance of losing $900, most people wouldn’t take this bet, even though it is a logical bet to take.
Studies have shown that loss aversion is so great that the average person needs a 2:1 gain-to-pain ratio before they are willing to take this bet. That’s why many trading gurus say “only trade when you have a reward:risk ratio of at least 2:1”. That specific number – 2:1 – it’s grounded in human psychology. There something about the human psychology that wants potential gains to DOUBLE potential losses. (That “double” almost seems like a magic, comfortable number.)
Conveniently, this is also why most investors and traders do no better than buy and hold. While the human mind craves for a 2:1 reward:risk ratio, very few trades actually have this reward:risk profile. Waiting for such optimal trades will result in you missing out on a lot of good opportunities, thereby causing your performance to deteriorate. (This is also why many people don’t go far in life. They are so concerned with “finding a sure thing” that they aren’t willing to take a calculated, logical risk on their careers, business, etc. Instead, they remain stationary, not going backwards but also not going forward.)
For example, the stock market goes up an average of 7% a year. A reward:risk ratio of 1.07 (potential gain) vs. 1 (potential loss) isn’t appealing to most people. That’s why no one gets excited when you say “you too can make 7% a year in the stock market”.
That’s why marketers (i.e. the media, many I-will-teach-you-to-be-rich gurus) have resorted to HYPE in order to sell their message. They either target your extreme greed (e.g. desire for “2” reward), or they target your fear (fear of “1” risk).
- This is why Bitcoin was so popular in 2017. “You too can make 100% a year from trading Bitcoin!” is a great marketing message. Who wants to make 10% a year in the stock market, when you can make 100% in Bitcoin?
- This is why the media targets your fear. The media (social media included) is constantly trying to trigger your fear year-after-year (e.g. “here’s why stocks will crash”), because that raises your attention.
It’s interesting how even the media has changed from targeting investors’ extreme greed to targeting their fears.
In the 1990s, CNBC and other media networks were cheerleaders for the stock market, because at the time it was indeed possible for tech stocks to soar 300% in 1 year. In order to attract your attention, they targeted viewers’ EXTREME greed.
But after the 1990s, it became very hard for stocks to SOAR. The stock market returned to a more normal pace of growth. So absent the availability of fodder for EXTREME greed, the media turned towards targeting fear, constantly saying “here’s why the stock market could crash 20-50%”. Bitcoin in 2017 was a short-lived return to the 1990s “target your EXTREME greed” mentality.
You can see this in social media as well.
- The most popular Youtube finance videos are all about “here’s how you can make 200% on this pot stock”.
- The most popular Twitter tweets are about “here’s why the stock market will CRASH CRASH CRASH”.
*This interesting juxtaposition partially comes from the fact that Youtube is more popular among younger audiences while Twitter is more popular among older audiences. Generally speaking, younger audiences tend to be too optimistic (because they haven’t experienced enough bad things in life) while older audiences tend to be too pessimistic (because loss aversion amplifies the probability of a bad event in the minds of those who have lived through those bad events. This is why the generations who lived through the Great Depression and WWII were generally more conservative and risk averse.)
Be careful with the media
I cannot stress this enough. Read the news, but don’t read too much. If you don’t read the news, you will be completely unaware of real risks in the market and economy. But if you read too much, be aware that the media’s goal is to grow their business, which means that they either:
- Target your EXTREME greed, or…
- Target your fears.
Some of the most successfull billionaires in the world don’t consume a lot of news. They know that the media has an agenda to portray gloom and doom, which is counter-productive to people who want to grow in a healthy, optimistic way.
Don’t oversimplify and jump to conclusions
Trading isn’t that easy. Investing isn’t that easy. Forming an accurate market outlook isn’t that easy.
To the best of your abilities, leave your existing biases at the door and remain objective. A lot of traders shorted stocks following the Trump election because they thought Donald Trump would be bad for the stock market (a personal opinion). Needless to say, they lost a lot of money in the ensuing rip-roaring rally.
Train your mind to think logically.
The human mind is constantly looking for 2:1 reward-risk payoffs. Such payoffs are rare, and waiting for these setups is counterproductive. Take logical bets.
Be aware of other people
Everyone has an agenda. That agenda can be as simple as trying to convince someone else. And when people try to convince someone else, they inevitably try to frame the statistic/facts in a way that best matches their agenda. This is just a part of human nature.
That is why you should always look at the facts and data for yourself, and then spend some time to think about the facts and data.