5 Trader Mental Models

What is a mental model?

It’s a way of thinking and acting that helps us work through problems, situations and opportunities. We use mental models so that we can simplify and make sense of the complexities in the world around us. The persona who has at their disposal a large number of these models, with a fair level of mastery, will be heads and shoulders above the average Joe or Josephine.

Let’s face it, the world is complicated and unforgiving, you can’t rely on just remembering a bunch of facts, you need an understanding of the way accomplished people have achieved their prowess in a number of disciplines. So while we will only cover a small cross section of the mental models available, this will be a great start. If you want more, then enroll in the Trader Master Course, where you will learn dozens of these models and how to become a consistently profitable trader.

1. The Scientific Method

Better knowledge can change the world but using your intellect is the best way to find truth, and that means understanding the most basic of all truth finding processes, the scientific method.

The method is based on integrating previous knowledge, observing, measuring, and logical reasoning.

Physicist Richard Feynman says that we need to be scientific in our research. He also said that it is not unscientific to take a guess. The key is to run experiments to prove whether your guess is right or wrong. By the way, did you know that most great discoveries were found first by guessing, then testing that guess? It’s true.

Why this is important to the trader?

When you perform statistical tests and experiments, you can challenge your guesses so that you are not just guessing and basing your investment decisions on unknowns.

We’ve all read books, blog posts and have seen webinars that make interesting and sometimes outrageous claims.

‘Do this and you’ll make a 20% return. This strategy works 70% of the time.’

But we can never know if these claims are true without running experiments and finding out for ourselves.

Conducting historical analysis, running back-tests, forward walks, and keeping a journal, where you collate data as you go along, are useful ways to do this.

2. The Law of Large Numbers

One of the fundamental underlying assumptions of probability is that as more instances of an event occur, the actual results will converge on the expected ones.

Let’s suppose that a trading system has a 90% win rate. The system looks great on paper but those results are based on a sample of only 10 trades. Over 1000 trades, the trading system might be a loser overall.

Scientific analysis can give you the statistics related to your trading and the more data you have the more accurate your findings and analysis will be.

Let’s say you backtest a trading system that returns 20% per annum but only trades two or three times a year. In this case you have a small sample size and you have to be careful that the results do not suffer from the problem of small numbers.

The more data points you have available the more accurately you will be able to define probabilities and come to conclusions.

3. Supply and Demand

The law of supply and demand is one of the most basic economic laws, so it’s a crucial theory for traders and investors to learn. The premise is that the availability of a particular product and the desire (demand) for that product affects its price.

Typically, low supply and high demand increases price, while plentiful supply and low demand cause price to fall.

For example, if a movie theatre cannot meet the demand for its showings, perhaps so many people show up that they have to turn some away, it will either put on more shows or increase the price of tickets, or both. If fewer people come to the theatre, and seats aren’t being filled, then either the price will need to come down, or the theatre will need to show better films and create more demand.

The Case Of Oil:

Supply and demand can be a complex matter with several factors affecting price, such is the case with crude oil. Around the middle of 2014 the price of one barrel of crude oil was trading at around $120 but by January 2016 the price had fallen to less than $40 a barrel, a fall of over 65%.

According to analysts the fall in oil price was driven by a major shift in supply and demand forces, following is a summary of those market forces:

  1. Slowing global economic growth. (This saw reduced demand).
  2. Rising global oil production as a result of several years of high oil prices. (This increased supply).
  3. Unexpected resumption of oil production in Libya, Nigeria, South Sudan and Iraq. (Increased supply).
  4. Increasing energy efficiency in terms of oil production techniques. (Increased supply).
  5. Record oil output from Russia. (Increased supply).
  6. The resumption of nuclear power stations in Japan. (Reduced demand).
  7. Natural gas and renewable energy sources eating away oil’s market share.(Reduced demand).

You can see from these points how the price of oil came to reflect supply and demand dynamics forcing price to a much lower level.

4. Fear Of Missing Out (FOMO)

FOMO is increasingly used to describe the angst associated with using social networks and the effect of living in our connected age.

It’s described in the Oxford English Dictionary as “Anxiety that an exciting or interesting event may currently be happening elsewhere, often aroused by posts seen on social media”. But FOMO also has implications for financial trading where anxiety can be aroused through the missing out on financial profit and this feeling is often exacerbated by the abundance of financial news coverage and commentary on the web.

For instance, here are some examples of FOMO in Trading:

  • I missed my entry price in Apple stock and now it’s gone up $10 already. I can’t believe I missed making that trade and losing that profit.
  • Everyone is making money in biotech stocks and I’m losing money in energy. I really wish I was trading biotech like them.

If you experience FOMO ask yourself whether the anxiety felt is an accurate reflection of reality, or whether it could be a result of other human biases and distortions.

For example, if you followed your trading plan correctly and you still feel that you missed out, you’re likely suffering from cognitive dissonance.

If you secretly wish you were trading a more exciting sector, one that you don’t know much about, then you’re violating your circle of competence.

If you missed a trade that went on to make a profit, then you may want to re-check your processes and also consider hindsight bias.

It’s not always easy to know which model applies to which situation, as everyone is different. But it is important to realize that careful, scientific analysis is the most sure route to finding success and that you are the only one responsible for implementing that.

5. Confirmation Bias

What a man wishes, he also believes. Similarly, what we believe is what we choose to see. This is commonly referred to as the confirmation bias. It is a deeply ingrained mental habit, both energy-conserving and comfortable, to look for confirmations of long-held wisdom rather than violations. Yet the scientific process – including hypothesis generation, blind testing when needed, and objective statistical rigor – is designed to root out precisely the opposite, which is why it works so well when followed.

The modern scientific enterprise operates under the principle of falsification: A method is termed scientific if it can be stated in such a way that a certain defined result would cause it to be proved false. Pseudo-knowledge and pseudo-science operate and propagate by being unfalsifiable – as with astrology, we are unable to prove them either correct or incorrect because the conditions under which they would be shown false are never stated.

“I never allow myself to hold an opinion on anything that I don’t know the other side’s argument better than they do.” – Charlie Munger

So, keep an open and scientific mind. Run experiments and remember to look at all sides.

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