Mind Over Markets Part 2: Think Big

2月14日

Welcome back to "Mind Over Markets," where we delve into the intricacies of trading psychology. In Part 1, we explored the concept of asymmetric payoffs. Now, in Part 2: Think Big, we unravel the impact of the often-overlooked cognitive bias – the Law of Small Numbers – and how mastering it can turn fear and greed in your favour, urging you to think in large sample sizes.

The Cognitive Pitfall: Law of Small Numbers

When trading, cognitive biases are ever-present, influencing our decisions and potentially leading us astray. While many traders are familiar with biases like overconfidence and loss aversion, the Law of Small Numbers often lurks in the shadows, waiting to trip us up.

Understanding the Law of Small Numbers:

This cognitive fallacy involves drawing sweeping conclusions from limited data – assuming that a small sample mirrors the broader market reality. In simpler terms, it's akin to expecting a fair coin to balance perfectly after only a handful of flips. In trading, where emotions run high, this bias can be particularly damaging.

Trading and the Gambler's Fallacy:

The Law of Small Numbers often fuels the gambler's fallacy in trading. Traders may believe that a sequence of trades deviating from the norm will inevitably correct itself. In reality, deviations can persist for much longer than expected as we are not programmed to think big, to think in large sample sizes.

For example, you have done your background analysis and believe that Stock X is oversold and likely to bounce. Your trading plan is to take bullish reversal patterns from short-term levels of support. Your first four trades are losers as the stock continues to trend lower, nothing has changed from your original analysis and you now believe the stock is even more likely to bounce so you risk more – leading to misguided overconfidence which in tern can lead to a cascade of poor trading behaviours.

Conversely, if a trader is trying a new strategy and his first five trades are winners, he will likely believe that his strategy has a clear edge – causing him to scale up quickly to maximise the hot streak of his new strategy. As his sample size increases and his performance deteriorates, he realises that he placed far too much emphasis on those early trades.

To avoid falling into the trap of the gambler's fallacy fuelled by the Law of Small Numbers, traders should recognise the importance of a large and diverse dataset for drawing meaningful conclusions about market behaviour.

Step Off the Emotional Rollercoaster and See the Bigger Picture

Every market event becomes a lesson laden with emotions – the elation of a win or the frustration of a loss. The danger lies in attributing undue significance to individual trades, driven by the emotional flags associated with those events.

This emotional turbulence can distort the perception of data and lead to flawed conclusions.

While complete eradication of cognitive biases is impossible, awareness serves as a powerful ally. Traders need to cultivate the ability to think in larger sample sizes such as 50-100 trades avoiding fixations on individual trade outcomes.

Practical Strategies to Navigate the Law of Small Numbers:

Trade Small and Think Big: Shift the focus from individual trade outcomes to analysing trends and patterns over a more extensive series of trades. To do this, traders must trade small enough that they are not concerned about the impact of a small sample of trades. Start small and scale up.

Performance Over Profits: The goal of trading should be to collect a high quality sample of data in a size large enough to draw statistically significant conclusions. To achieve this, your focus must be on following your rule set, not on obsessing over profitability.

Make it Your Mantra: The ability to think in large sample sizes is not easy. To achieve it, it must become part of your identity as a trader. Simply by writing ‘Think Big’ on a post-it note and sticking it to your keyboard will help you to make thinking in large sample sizes part of your identity.

The Beauty of Thinking Big:

The number of cognitive biases associated with trading are truly vast and to list them all would send you to sleep.

Taking practical steps to overcome the Law of Small Numbers, ensures that you’re killing multiple cognitive biases with a single stone. By thinking in large sample sizes, you’re dramatically reducing the impact of overconfidence, loss aversion, and hindsight bias to name just three.

Stepping back and thinking big, has the potential to put you on the right path in your trading journey.

Disclaimer: This is for information and learning purposes only. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance. Social media channels are not relevant for UK residents.

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