Standard economic thinking would have you believe that the bigger the financial incentive the better you will perform. The idea is that if I pay you more money you will exert more effort and will do the task better.
That’s actually partly true. Uri Gneezy, an economist at University of California at San Diego, paid college students $300 instead of the usual $30 to type a sequence of keys on the computer. Accuracy rates went up from 40% to 80%. For mindless rote activity higher incentive produces better results.
However, that assumption fails miserably when the task at hand requires even a modicum of cognitive ability. The same experiment of paying students tenfold to add a series of numbers in matrices showed a massive decline in success rates from 65% to just 40%.
An even more striking example of this dynamic occurred in poor regions of India where Gneezy ran an experiment asking people to pack tools in the most efficient manner. Participants were paid 10 cents, 1 dollar and 10 dollars each (10 dollars represented a month’s worth of wages for that cohort) At $1 per task 25% of participants succeeded in the task. When the payoff went to $10 every single person who took test failed it. That’s a remarkable insight into human psychology and goes a long way towards explaining why when you decide to “size up” on the exact same setup that you’ve been trading for years you suddenly start to bleed money.
The greatest thing about trading, aside from the potential for profit, the intellectual challenge of finance and the emotional engagement of the game is that the markets are probably the purest, biggest psychological laboratory in the world. If you are honest with yourself and step back to examine it you would have to admit that trading has probably revealed more about your true personality than any other activity you’ve ever done. Good or bad, the markets lay you bare in front of the world in ways that few other things in life do.
I was thinking about that a lot this week, after listening to a wonderful System Trader podcast interview with Mandi Pour Rafsendjani who, instead of focusing on yet another mind-numbingly boring quant system talked about what it really takes to be a successful trader. It’s a wonderful episode and I encourage you to listen to it – but there were a few key points that she made which I thought were amazingly perceptive.
First and foremost if you are anything like me you probably got into trading for the sense of autonomy. You hate being told what to do. You hate working under other people’s rules and you like the sense of freedom that trading brings you, even with all of its crazy risks. But if you are that type of rebellious person, yoa u probably also hate paperwork and bureaucratic processes and record keeping. After all – you are trader, not a bookkeeper!
Yet Mandi makes a very interesting point that it is precisely the structure of record keeping that is the gateway to the freedom you seek. Because it is only through record keeping that you will be able to improve. Mandi, who has interviewed scores of traders, notes that winners focus on facts and figures while losers focus on feelings.
Still, the record keeping she has in mind is unlike any you’ve ever seen before. Mandi will be the first to tell you that if you don’t have a setup that you can write out on the back of a napkin, you have nothing. In short, you need a clean, clear set of rules that will guide your trading. But keeping score of the winners, the losers, the drawdown, the entry and exit permutations, the instrument selections and all other usual suspects of trading is just the beginning. In fact for us in FX, the act of record keeping can be 99% automated with journaling websites like www.myfxbook.com.
When Mandi talks about record keeping, she has something else in mind entirely. She believes that record keeping of your state of mind is just as important as journaling your trades. Here are just some ideas she shares. Do you have a magic number of trades after which you get sloppy? For example, she notes that after five winning trades she tends to give a lot of her profits back. So now she simply walks away from the screen and works LESS. What about treating same trades in a different way? For example, when a trade initially goes into profit and then into a loss, do you have a hard time taking the stop versus a case of when a trade goes negative right away? (Guilty!) What about fixating on reaching a key dollar figure on your account equity (like say $10,000) which forces you to leave trades open because they haven’t reached your “target”? (Guilty!) What about trading a style that does not fit your personality because everyone tells you that’s what you are supposed to do? (Guilty!)
For me, the two greatest recent realizations have been that I am a serial, not a parallel trader. I do best when I trade one position at a time. (Read my New York subway column from a few weeks back for more details on that) The second most important realization is that I always lose money if I trade without an execution algo. If I am tapping buttons on my MT4 iPhone app as I dart in and out of the subway – that is always the start of a journey to trading hell. I will ignore my sizing parameters, I will ignore my stops and I will inevitably cover for a loss after needlessly battling the market for days. On the other hand, if I am entering from a preset template off my well worn MT4 EAs, my control is assured. I may win or I may lose, but either way, I will do it properly and will not damage my account unnecessarily.
Using Mandi’s approach of recording your own state of mind as well as your trades has been an eye-opening process. The irony of her approach is that while winners may indeed be preoccupied with facts and figures while losers are obsessed with feelings, the key facts and figures aren’t actually the standard trade blotter, but the emotions you go through as you establish your trade. Losers may focus on feeling, but winners focus on recording and studying those feelings on a continuous basis. What becomes very clear as you listen to the podcast, is that profitability in trading is much less a function of tweaking your system parameters and much more the case of minimizing your tendency to make psychological errors. Walking away from the interview you realize that the single most important trading system is – YOU.