Friday, May 1, 2015

Experts, Novices, and Trading Performance

A large body of research examines skilled performance in various fields by comparing
experts with novices. These fields range from athletics (both team and individual sports)
to chess to various performing arts. Having now read scores of books and research
studies on the topic, I see where much of this research could be of value to traders
seeking to achieve their own levels of expertise.
A book that I am planning for 2006 will chronicle these investigations--and their
implications for trading--in considerable detail. This article will focus on one particular
finding of interest from studies on expertise in medical diagnosis: the differences in
reasoning styles between accomplished professionals and neophytes.
Having taught in a medical school for 19 years (and having traded stocks and equity
indexes longer than that), I can vouch for the similarities between arriving at medical
diagnoses and coming up with trade ideas. Both involve an initial absorption of detail,
followed by a comparison of the details with known patterns, and then a sharpening of
one's ideas prior to taking action. Traders and physicians alike bring with them mental
maps of familiar patterns based upon didactic learning, research, and personal
experience. In that sense, a trader's assessment that we are moving higher is not so
different from a psychologist's diagnosis of an anxiety disorder. The trader knows what
trending markets look like--including certain configurations of price, volume, and
volatility--and the therapist has an internal representation of anxiety disorders. Pattern
search following careful observation is crucial to their expertise.
It turns out in the medical expertise literature that novices (such as beginning medical
students or laypeople) lack the internal representations of experienced professionals and
thus have a harder time making sense of the data they collect. Such novices will collect
blood test results, physical findings, and data from the medical history in a far more
haphazard fashion than experts, creating both inaccuracies and inefficiencies. Most
crucially, the novices employ what researchers call "backward reasoning": they jump
from initially presented information to diagnostic impressions and then move backward
from their impressions to identify data that support their views. For example, an
inexperienced psychology student might observe low energy in a patient and leap to the
impression of depression. From this impression, the neophyte therapist would ask
questions that would be relevant to mood disorders generally and depression specifically.
Expert doctors, however, do not function this way. They employ "forward reasoning".
They collect a wide range of data that are relevant to making differential diagnoses.
Instead of jumping to a single conclusion, they have in mind several possible conclusions
and collect the data needed to distinguish among them. Thus, for instance, the expert
therapist would seek a blood workup and a full history and physical to accompany the
usual psychosocial questions regarding mood. This is because the expert knows that low
energy in a patient can be the result of hormonal imbalances, nutritional deficiencies, and
disease processes--not just depression. Where the novice works backward from an initial
impression, the expert assembles large amounts of data into clusters and narrows
hypotheses until the best one remains.
It is not unusual for traders to become married to market opinions: They get an idea in
their head where they think the market is going and then they ignore information that tells
them otherwise. I have watched traders selectively pick information from markets that
confirms their biases while ignoring huge trends that are contradicting their ideas. Only
after their markets close do these traders look back and wonder how they could have
missed what was so obvious.
I contend that the trader who is married to an opinion is behaving like novices in the
medical expertise studies. They form an impressionistic view of their market and then
search for evidence to support their bias. Expert traders, however, "let the market come
to them": they gather enough information to sort out random movement from significant
tendencies, eventually arriving at trade ideas that represent their diagnosis of the market.
New traders, I've found, are like medical students in that they haven't received enough
training and seen enough variations of patterns to know how to assemble data into
differential diagnoses. Only with repeated experience do they learn to identify
meaningful clusters of information and use these to sort plausible ideas from implausible
If this is true, trader education might need to more closely approximate medical
education. Traditional medical education consists of a pre-clinical phase that teaches
basic science fundamentals, so that students understand principles of anatomy,
biochemistry, cell and molecular biology, pathology, and the like. After this comes a
very different clinical phase where learning is at the bedside, with students encountering
a variety of clinical cases and "reading up" on these. Traders, too, need a basic education
in the fundamentals of auction markets and statistics, so that they understand the
significance of bids, offers, volume, and price levels and patterns that appear over time.
After the basics, however, traders learn at their equivalent of the bedside: by viewing
markets under varying conditions and looking deeply into these.
Ultimately, what physicians and traders learn is not just a fund of knowledge, but a
method of reasoning. What makes a good trader may come less from the trade ideas
themselves than from the forward reasoning process used to generate these ideas.
Traders who keep journals and work on their performance may want to think about
monitoring more than their moods, trades, and profits/losses. They also need to think
about their thinking.

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