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Traders are rewarded based on their results and judgments, rather than their efforts.
Even marginal inefficiencies in the thought processes behind those judgments can lead to significantly lower rewards. And if left unchecked, especially during the formative years, it requires much more effort to unlearn than to learn. Let's dig deeper -
In his book "Thinking, Fast and Slow," Nobel laureate Daniel Kahneman introduces the concept of System 1 and System 2 thinking. These two systems represent the different modes of thought that our minds employ when processing information and making decisions. I have taken the liberty to paraphrase both his work and his words, as well as incorporate my own thoughts in this post.
System 1: Fast and Intuitive
System 1 thinking refers to our automatic, fast, and intuitive mode of thought. It functions effortlessly and without conscious control, enabling us to swiftly make judgments and take action in familiar situations. This system relies on mental shortcuts, and patterns to rapidly evaluate and respond to stimuli. Every time you recognize faces, drive a car on a familiar route, order groceries, or buy a stock using the same setup for the 1000th time, it's your System 1 in action.
System 2: Slow and Deliberate
In contrast, System 2 thinking is deliberate, effortful, and analytical. It involves logical reasoning, weighing evidence, and considering multiple perspectives before arriving at reasoned judgments. This system is used when we encounter new or complex situations, or when making longer-term impact decisions. Examples include solving a difficult math problem, buying a house, choosing a career path, or dealing with situational awareness in your early trading years.
Interplay between Systems
a) Systems 1 and 2 are both active whenever we are awake. System 1 runs automatically and System 2 is normally in a comfortable low-effort mode in which only a fraction of its capacity is engaged. However, continuous effort on System 2 activities make them easier and transform them into System 1 tasks. For instance, when we begin trading, we spend a lot of time pondering over numerous minute details on a chart. Over time, managing these factors becomes easier due to our procedural memory. This parallels the experience of driving, where we are initially hyper-aware of every vehicle, even those 50 meters away, but eventually it becomes routine.
b) When things go well, System 2 usually accepts System 1's suggestions as is or with slight modifications. However, when System 1 faces challenges, it relies on System 2 for more detailed processing to potentially solve the problem. For instance, when a car driver overtakes a truck on a narrow road, adult passengers usually stop talking. Likewise, if you encounter multiple stop losses, experts advise taking a step back to review your trades.
c) System 1 thinking is quick but prone to biases and errors. It relies on mental shortcuts that can lead to snap judgments and cognitive biases. System 2 thinking is more reliable and accurate, but too slow and inefficient to replace System 1 for routine decisions. Also, laziness is inherent in human nature and the "Law of least effort" applies: When there are multiple ways to achieve a goal, people tend to choose the least effortful path. Effort is viewed as a cost and skill acquisition is influenced by the balance of benefits and costs.
Impact on trading
We often develop false or untested FAITH in our trading skills when our System 2 is lazy or preoccupied and chooses to believe the easier (but flawed) System 1 alternative in the following situations -
Authority
Many of us learned about momentum trading from books and online courses, copying patterns, indicators, and rules from experts like @markminervini, O’Neil, @PradeepBonde, or Darvas. The author's System 1 automatically became our System 2.
This is a natural learning process, but it leads to theory-induced blindness: Once you have accepted a theory and used it as a tool in your thinking, it is extraordinarily difficult to notice its flaws. Even when you encounter observations that contradict the theoretical model, you often assume that there must be a valid explanation that you are somehow missing. This phenomenon occurs to all of us in almost every aspect of life, including religion, business, and politics. The confidence that individuals have in their beliefs often relies on the quality of the narrative they can construct about their observations, even if those observations are limited.
"Buy Right Sit Tight" investors often misinterpret value investing, selectively quote Buffett, and cherry-pick examples to justify their thesis or average down on their investments. This is also frequently observed among pattern and indicator-based traders who strictly adhere to technical books or their first derivatives. These books aren’t incorrect, but the broad "pleasant sounding" generalizations conceal specific flaws within them. Oversimplifications are often made as a business decision to appeal to our more instinctive System 1 thinking or to improve distribution and marketing.
Frequency
Joseph Goebbels, a Nazi propagandist, famously said, "A lie told once remains a lie, but a lie told a thousand times becomes the truth.” This quote may be a bit too dramatic in the context of trading, but frequency and repetition are primary tools of most content creators, performance marketers, and fintwits. Repetition makes statements easier to process relative to new or contradictory statements, leading people to believe that the repeated conclusion is more truthful (even if it isn't). While it may not be harmful for entertainment or sports, it is detrimental for trading.
Our System 2 guards are normally lowered when we doom scroll through Twitter or Whatsapp. This often leads to the "illusion of truth" when empty persuasive messages, supported by like-minded followers, start shaping our System 2 trading beliefs. This invisible backdoor often had an effect on my System 1 actions, as the constant exposure to prototype VCP setups and repetitive statements about "risk management" were seeping into my trading performance. It is ironic that I am writing this on Twitter, but I have found it helpful to unfollow accounts or mute groups that post generic content too frequently, cry wolf at every market pullback, or oversimplify trading with catchy phrases and trendlines. Having a high content frequency may be beneficial for the creator's business, but not for the trader's business.
Inputs on System 2 refinement
a) Most of our trading blocks are encountered in situations where there are no perfect answers or where the outcomes cannot be standardized. This typically occurs when our System 1 shortcuts become untested System 2 beliefs. Adopting a Deep Work practice (by Cal Newport), will help you approach bigger questions by breaking them down to their first principles and smaller actionable questions.
For example - Traders often encounter a common problem in bull markets: the challenge of selecting 2-3 setups from numerous options or regularly entering setups that are squatting while others in the watchlist are moving.
Breaking it down to smaller questions-
Not all good stock charts are equal. What are the differences in their base duration, quality, and pivot? Are there any sectoral or earnings catalysts? Is there a higher fomo in demand compared to others? Is it the start of a new trend or an IPO? Is it a trade for a magnitude move or a short momentum burst? Can I enter the trade early and reduce risk compared to others? Is it liquid enough to easily pyramid and exit?
Action Steps -
1) Write down your daily watchlist, highlighting the trades that were triggered and the trades you took (List 1).
2) At the end of the day, scan stocks that closed more than 4% higher. From this scan, create another list of stocks that you could have taken (List 2).
3) Now compare the charts of List 1 and List 2.
Over time, you will start to notice differences in the setups and find answers to the questions you asked at the beginning.You would also notice that setups and trendlines are shortcuts used by our System 1 to save time and reduce daily cognitive load. They are not System 2 decisions. First hand validation that setups work (sometimes) because of the trend and demand behind them, instead of the other way around, will significantly improve your stock selections. This will put you in stronger momentum stocks, rather than solely relying on visually appealing patterns.
b) It is suggested to focus on deep work on only one demanding problem at a time. Otherwise, we often tend to substitute the initial tougher question with an easier one.
c) Our System 2 beliefs improve through repeated testing from different perspectives. It is helpful to consider price movements from the standpoint of other market participants and how these movements influence their decision-making. For example, as a momentum trader, it would be advantageous to grasp the concept of value zones and value investing in order to enter momentum earlier. Similarly, as an investor, there is greater marginal utility in studying timing from charts rather than spending excessive time on annual reports and narratives.
Closing Note
