A Cognitive View of Trading Psychology

A common view, held among traders and coaches of traders, is that emotional factors account for the difference between trading success and trading failure.  Some hold that emotions should be controlled, held in check, and made secondary to the discipline of rules.  Others hold that emotions should be accepted and experienced in a mindful way and, when possible, used as information.  In either case, the goal is to ensure that decision making is achieved through a proper trading process and not driven by the emotional experiences and impulses of the moment.

I believe this emotive view of trading performance is incorrect and, in fact, is not plausibly asserted in any other performance domain.  No one, for example, would contend that the path to reaching grandmaster status in chess is a function of successfully dealing with one's feelings.  Emotional self-control, while necessary for exemplary performance, is hardly sufficient.  Very often, emotional loss of control is the result of poor performance and not its primary cause.

Consider an algorithmic trading system that has been overfit, using many predictors over a lookback period to anticipate future price behavior.  Such an overfit system has negative expected returns, but hardly because emotional factors have interfered with its performance.  Rather, it is generalizing from improperly derived rules, assuming that the future will rigidly replicate the past.

My years of working with traders as a performance psychologist have led me to the view that success in financial markets is more a function of cognitive strengths than emotional/personality ones.  Moreover, my experience has suggested that these cognitive strengths are domain specific, rather than domain general.  That is, the skilled trader develops ways of thinking about markets that are unique and distinctive to financial markets and doesn't simply develop general reasoning skills that would lead to success across fields of performance.

An analogy would be the performance of a physician.  The skilled physician picks up on symptoms, takes a good history and physical, decides upon tests to conduct, assembles the findings into one or more plausible diagnoses, conducts more tests to differentiate among the diagnostic possibilities if necessary, and eventually finds treatment options based upon the preferred diagnosis.  All during this time, the skilled physician is maintaining a good rapport with the patient and engaging the patient in a supportive way, encouraging the patient to be as forthcoming with information as possible.

Should the physician get the diagnosis and treatment wrong, we would not immediately assume that emotional factors got in the way of a successful outcome.  Rather, we would look for breakdowns in the physician's reasoning and decision-making process.  This process is domain specific in that it is not used by professionals in other performance-related fields.  The reasoning process of the chess grandmaster does not resemble that of the physician and neither resembles the reasoning of a successful daytrader. 

(Notice in the case of the physician that more than one reasoning skill may be at work simultaneously.  The judgments involved in sensitively engaging the patient and maintaining rapport are different from those used to navigate a decision tree for diagnosis.  For a successful trader, the reasoning used to identify a worthy investment could be quite different from the reasoning used to determine when to make that investment.  The skill needed to accurately diagnose a tumor is different from the surgical skill needed to remove it.)

When trading firms *have* shown interest in cognitive factors when recruiting traders, they often have looked for general competencies rather than ones specific to the trading domain.  Thus, for example, they might have candidates perform a general reasoning test or they might look for good grades on a college transcript.  When I was teaching full-time at the medical school in Syracuse, I was surprised by the fact that grades in college *did* predict medical school grades--but only in the first two years of classroom-based medical education.  College grades and even grades in basic science courses in the initial years of medical school were not meaningful predictors of clinical performance with patients.  Knowing how to study for tests did not correlate highly with knowing how to engage patients, navigate decision trees of diagnosis and treatment, and implement actual procedures.

The domain specificity of the cognitive processes that contribute to successful trading performance helps to explain one observation that has always struck me.  Traders trained in classroom-like settings (or left to their own devices to learn trading through reading books and watching screens) rarely achieve success.  I consistently observe the highest hit rate on trader development in situations where the new trader directly observes the experienced trader and models the behavior of that more senior professional.  In other words, trading is not learned through general learning mechanisms (classrooms, study), but through very specific observation and modeling.

It is not coincidence that medical education starts in the classroom to gain basic knowledge of physiology, biochemistry, and pathology but then quickly moves to the clinics and hospital floors to allow for shadowing and direct observation of practicing physicians.  You learn to treat a patient by watching competent physicians treat patients and by modeling their decision-making processes and domain specific skills.  No amount of reading or self-study could help a student become a successful psychiatrist or gynecological surgeon.

The domain specificity of trading skill also helps explain why very intelligent people often don't make for very successful traders.  Other traders I've known who are quite successful in markets are notably weak in their performance in other areas of life (as parents and spouses, for example, or in the conduct of their own personal finances).  Several trading firms have been known to look for potential trading stars by recruiting successful poker and video game players.  They are hypothesizing that the skills specific to those performance domains are generalizable to trading.  That focus on domain specificity is one of the rare pieces of recognition that it takes more than emotional discipline and awareness to succeed in trading.

All of us have two eyes, but many of us have different views.  It's what happens cognitively--in our information processing--that determines how perceptions become expressed as views.  Traders truly interested in developing themselves as professionals need to do what aspiring chess masters and physicians do:  learn from the masters.

Further Reading:  Controlling Emotions is Not the Goal of Trading Psychology

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