Why we make bad choices

Here’s a question for you …

You’re faced with a urn which contains 30 red balls, and an unknown number of black and yellow balls, which add up to a total of 60, meaning there are 90 total balls in the urn.

You’re given the choice of two sets of gambles you can take:

Gamble A: you win £100 if you draw a red ball from the urn
OR
Gamble B: you win £100 if you draw a black ball from the urn

and

Gamble C: you win £100 if you draw a red or yellow ball
OR
Gamble D: you win £100 if you draw a black or yellow ball

Which do you take?

If you’re like most people, you’ll have chosen gamble A and gamble D, because both of these options have known probabilities.

With gamble A, we know we have a 33% chance of pulling out a red ball from the 90 in the jar. With gamble D, we know we have a 66% chance of pulling out either a black or yellow ball.

However, there’s a flaw in our logic, because the first gamble assumes that there are more red balls than black ones – a scenario which would make gamble C a better choice for the second bet.

This quirk of human brains is also called ‘ambiguity aversion’ – we’ll generally choose risky situations over ambiguous ones.

So, how does this affect our trading decisions?

If human beings have an aversion to unknowns, then they will naturally move towards ‘safe’ investment decisions. They’ll go with something tried and tested, with a fixed return, which feels safe and reliable.

I guess it’s why so many people put their money in savings accounts.

If this is true, then as traders we’re already bucking this convention – we’ve taken a decision to seek out higher returns, and the flip-side of the decision is that we’re taking on the ambiguous.

What makes traders behave this way?

Well, psychologists have linked a particular personality trait with people who show less ambiguity aversion – and that’s optimism. And it would certainly seem that traders are naturally optimistic people.

A natural optimism that drives us to look for better income streams and to improve our financial health is a great thing …

… but, a natural optimism in individual trading decisions … well, that can be dangerous.

It can lead us into terrible decision making like … ‘I’ll double my stakes to win back what I lost on the last two trades’ … ‘I’ve had four losses in a row, so I must be owed a winner’ … ‘The last 3 trades have won, so I’ll double my stakes for the next one to take advantage of this winning streak’ …

So, we’re faced with a contradiction …

The same optimism that led us to seek out improved returns for our money, can also lead us to make poor decisions with that money in the market.

But we don’t need to be stuck in this dead end – all too aware of our own weaknesses and failings, traders have already come up with a solution …

The rules-based trading strategy.

Most successful traders rely on rules-based, regimented trading systems. This is true of home traders following a list of rules they’ve written down themselves … to professional investment strategies that use complex algorithm programs … and everything in between.

These rules stop us from following our hunches, or just crossing our fingers and hoping that luck will be on our side.

Instead, they rely on research, testing, and retesting.

Even traders who do rely on judgment calls on their individual trades, will still have a set of rules that must be fulfilled before they’ll even consider a trade.

This style of trading helps us to keep disciplined and to quieten the battle that’s going on between our optimistic side of our nature, and the side that’s averse to ambiguity.

The thing about ambiguity is that it can be the traders best friend … and his worst enemy.

Ambiguity is the thing that adds risk to your trade – and it’s the reason why we can make money. The fact that we’re prepared to accept the unknown about which trades will win and which will lose is why we can get our superior returns.

But at the same time, we need to keep disciplined.

There’s a really interesting experiment carried out by a scientist called BF Skinner in the behaviour of rats.

If the rats were randomly rewarded with food for pressing a lever (ie sometimes they got food, sometimes they didn’t), they became obsessive lever-pressers, never knowing which press will bring them a reward.

You can probably already see where I’m going here …

There is always an unknown element in our trading.

We need to be sure that we don’t turn into rats frantically hitting a lever.

Sure, there’s ambiguity in trading – we can’t know which trades will win.

But we can find patterns and develop strategies to give us an edge. It’s this knowledge of winning percentages that makes our behaviour rational.

And not just like rats hitting that lever!

The crucial thing to note from this is that what we believe are logical decisions are often very flawed. I’m sorry to say this, but human beings are rubbish at weighing up risks and making a rational choice – especially in the heat of the moment.

But we can be good at building disciplined, rule-based strategies, and following them. These systems can be a piece of software that automatically trades for us … or scribbled on a piece of paper. What matters is that it’s based on solid research, it shows a clear edge of the market, and we are able to follow those rules to the letter.

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