Winning traders must identify profitable trading strategies. It’s a creative process. Much like scientists find evidence to support a theory, traders must formulate hypotheses and determine whether their proposed strategy can produce a profit. You must sift through a wealth of information, mentally testing and retesting your hypothesis and trying to decide if it will work when the ideal market conditions are present.
In searching for a winning strategy, there comes a point when you start to believe that you’re right. At some point, you must stop deliberating whether or not to go with a particular strategy, and make a final decision. But you don’t want to jump in too early. On the other hand, you don’t want to consider and reconsider your strategy so long that you miss a market move. The key is discerning when to stop deliberating and when to take action.
If you’re like many traders, however, you’ve made your share of bad decisions. Psychologists have studied the thought processes that go into making decisions, such as determining whether a trading strategy will work or fail. It’s a two-stage process, according to Dr Daniel Gilbert, a professor of psychology at Harvard University. When evaluating a strategy, there’s a point where you start to believe that it is true; in other words, you believe that your view of the markets is accurate and you’ll make a profit if you use the strategy. That is the first stage of the decision-making process, believing that you are right.
The second stage consists of determining whether or not you are actually right. The human mind seems to work in a peculiar way. In order to fully understand and mull over a hypothesis, we must first believe it is true, even if it is actually false. After we accept the hypothesis as true, we then go through a process of thinking and re-thinking the hypothesis before finally deciding if our initial acceptance of the hypothesis was a prudent decision.
For example, if you decided that a product announcement was going to produce a dramatic price increase in a company’s stock next week, you first accept that you’re right, Stage 1 of the thinking process. By accepting you are right, you build up the motivation to further study your hypothesis and decide if you are in fact right. It makes sense when you think about it.
If you thought that your hypothesis was wrong, you would just forget about it and move on. You might see how problems may arise in the way the mind works, though. What if you decided your strategy was right, but then stopped deliberating, instead of continuing to question whether or not you made a good decision? If you stop too soon and avoid Stage 2 of the thinking process, you’ll continually jump to the wrong conclusion and erroneously implement unprofitable trading strategies.
It’s vital that you think and rethink the strategy a little while longer. You must play Devil’s Advocate and think about what might go wrong. For instance, a product announcement won’t lead to a profit if media analysts report that the product will be a dismal failure. You must do a little extra research to decide if there is evidence of an unexpected event that may ruin your plan.
People often forget to fully evaluate their initial decisions. Why? Research studies have shown that when people are under time pressure, or tired and worn out, they do not fully deliberate their decisions. In other words, they engage in Stage 1 thinking, they accept that their hypothesis is true, but they avoid Stage 2 thinking; they assume their initial hunch is right without fully considering evidence that may refute its veracity.
When making a trading decision, fully deliberating your alternatives is essential. You don’t want to over-deliberate, but you don’t want to be impulsive. Don’t rush the decision-making process. Slow down, and realize your limitations. When you are overloaded with too much information to sift through, or you are just too tired to think straight, you will make an impulsive judgment. Make sure you are rested and relaxed. By staying psychologically alert, you’ll increase the odds of choosing winning trading strategies.