Negative Bias Beliefs: How They Destroy Your Trading (and help) // Ep. 25

In This Episode

• The guy who says that nobody should trade
• How to stress test a suspicious trading system
• How to tell if you're really an optimist

Everyone has Negative Bias Beliefs and That's Why Many Traders Fail

Negativity bias is not all bad.

In real life situations, it can help keep us out of trouble.

But in trading, it can really trip you up. Learn how to use a healthy amount of your negative bias and remain more centered.

This leads to more “realistic” trading and gives you a much better shot at success.

Read the Transcript:

Hugh: All right so in the last episode we talked about cognitive biases. So let's talk about negative biases; how does that affect us as traders and where does that come from?

Walter: Negative biases. Well, I think for people considering what can go wrong is adaptive. Who's going to survive? Like the mother who's so concerned about her child that she makes sure that every little thing like, you grow up in the rain forest down in South America you know the mother's concerned about pythons getting her baby. 

So her family, her kids are the ones that survive because the pythons never get her kids sort of thing. What do you call the neanderthal guy who's worried about woolly mammoths trampling on his tribe? His tribe survives. So it's adaptive in a way like anxiety and assuming that the worst is always going to happen. To me that's kind of like it's an adaptive thing, I guess. You could argue and so that's useful in that sense.

In trading it's a little bit different because you do need that; you need that when you're considering risk because it's a matter of risk and reward but at the same time I think a lot of traders they don't get into trading thinking about that. I didn't get into trading considering probabilities. I didn't understand that until later. I got into trading thinking about the reward. I didn't think of the risk. Everyone's Scrooge McDuck.

Hugh: Hey there! I hope you find this episode useful. I just want to let you know that Walter and I give away something valuable every month that helps traders improve their skills. You can enter to win by simply leaving an iTunes review and leaving a comment on our YouTube videos.

At the end of each month, we'll look at the comments and reviews from the month and we'll pick a winner at random. Each comment and each review counts for one entry during the month that it's pitted.

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Walter: I think you need that bounce. I mean, you can go the other way if you're too concerned about risk. I've seen that too and those traders, what they end up doing is limiting their possibilities.

I'll tell you a story. Just this week, I was working with the trader and he was showing me his strategies. He was like, “Look, I got this strategy you know it's pretty good. I’ve got this other strategy, looks pretty good. I think they both work in the same type of market like a trading market or whatever but then I put them together and it's freaking unbelievable.”

I go, “Yeah, it is unbelievable; that looks really good.” He goes, “Doesn't make sense you know” and so he was trying to tear it down. He's like, “I want you to show me why when I put these two strategies together which seemed to be you know they would work in the same market, why would the equity curve get so like exponentially better.”

I said, “Yeah, that's weird” I said, “You know, let's look and see if these two strategies are actually kind of taking the same trades.” Turns out they had a 0.08 correlation. One was zigging while the other one was zagging. And that's exactly why his equity curve went straight up and that was awesome to see. 

What's cool about this is he didn't just jump in straight away and go, “Oh my god, I have these crazy strategies. I put these strategies together and I'm in the money”. What he did was he said, “What's wrong here? What am I missing? What did I get wrong? Can you show me something blah, blah, blah”.

I said, “You just got to run the correlations. It's a question.” He's like, “Okay” and we know we're looking at the distribution. You're trying to put the equity curves together and I'm like, “No man, just run the correlation. Let's just see and then we'll test it on out of sample data to make sure.”

So that's what he did. He had the right approach you know. He's a very data-driven dude; that's how he looks at things. He was like, “Where am I gonna go wrong here?” I think that's a healthy approach. To have that negative like skeptical kind of thing.

Here's the question. You probably heard this too. People say, “Well, how much can I make money? How much can I make trading Forex?” What they're asking you to do is, they're asking you to take your limits, your limitations, your beliefs and place it into their head; that's what they're saying. 

They're saying, “Give me the universe that I am going to live in. You tell me what I am going to do”. Like a parent telling the kid, “You can only have an IQ of 115 after that I'm cutting you off. You're on the streets” or whatever like that's crazy. It's totally crazy but I understand because we're taught to accept authority; whatever authority tells you, that's the right thing and all that stuff.

I mean, I get it in a sense but I think we need a healthy dose of negative expectations of feeling like things are going to go wrong or where can it go wrong. Especially when we're in a system constructing you know and building that strategy and tweaking the risk. Trying to figure out how much because your biggest draw down is always in the future. All that stuff is important but if you're too far that way, I've seen that too.

I've seen guys who've been trading for decades and they go, “You know what? I don't think anybody should trade.” What are you talking about? You're a trader. He's like, “Yeah, I don't.” Do you know what I mean? They've just gone the other way. They've totally gone the other way. 

Is that what you meant by this? I just want to make sure that we're clear on that.

Hugh: Yeah, that's really good. That's interesting that you mentioned the limitations because I've gone to a couple of presentations. Obviously, a lot over the years and one guy at a meetup was saying, “How much can you make trading?” He was like talking super loud, trying to be really convincing.

People threw out some numbers and he said, “No. You can only make ten percent a year at the most” and I was like, “Wow!” That's really limiting people but that was his world. I don't think he was trying to be negative; he's just trying to be realistic within his version of reality but wasn't necessarily other people's versions of reality, obviously.

Walter: Yeah, obviously. We have Nicola in the forum and she does way better than that you know. There's people that are out there that it's crazy to me. It's so true man like that guy, I really believe he didn't — the guy that you're talking about — he didn't mean to do anything to hurt people or send them the wrong way you know.

Here's the thing, here's a good test. If you ever see someone and they say, “I'm an optimist” don't believe it and if they say it like a self-proclaimed optimist. This is my belief: if somebody is an optimist, it will be super clear. You will know it.

Hugh: They don't have to say it.

Walter: No, they're not to say it because why would they? The other one is and this is, there's even way more of these people I believe. I think it's adaptive that's why as people would say, “I'm a realist” don't believe it; they're pessimists. 

It's so true. Optimists never say that they're optimists and pessimists always say that they're realists.

Hugh: That's a good point I never thought of that.

Walter: Yeah, it's so crazy but it's exactly kind of what we're talking about. The perfect trader is the trader who goes into the system construction phase going, “Total, I'm a realist” which is you're a pessimist. When you get out of it you just gung-ho optimist. Especially when you have a low win rate, you just gung-ho. 

I'm testing a strategy now that has a thirty-eight percent win rate and it's tough. It's tough but you get over it after a while. You learn to keep chopping wood knowing that you'll make it all back when you get the nice big fat winners and stuff like that. It’s so funny like that to me it is a really good test. Just in life if someone says, “I'm a realist” or if someone says, “I'm an optimist”, in both cases they're wrong. I'm sorry.

Hugh: I guess, ideally we would like to be in the middle and know when to go which either way.

Walter: Like pros and cons. Just like the classic guy or girl or woman or whatever who when you ever make a decision, you draw a line down the middle of the page: pros-cons. You don’t  have to say I'm a realist. You can just see people making decisions that way.

I always think about my grandfather like I say, “What would he do?” What I mean is like that's how I try and step into the mindset of someone that you admire or whatever. I think you're right. The realist would never say I'm a realist and the realist would be that person who does the whole I don't know, somebody famous came up with that. I don't know who it was but you see the pros and cons.

Hugh: Was it Benjamin Franklin?

Walter: Yeah, I think you're right; that's what I wanted to say. Someone like Franklin who came up with that. The pros and the cons whatever; there was a Simpsons episode where Homer was trying to be like Thomas Edison. 

Homer Simpson was like, “I'm going to be like Thomas Edison. He is my hero” or whatever so he was going to do everything that he did and invent all these things. It was so funny. I always remember that episode, it's classic. So writing down the pros and cons, that's how you know you're a realist because it's both sides. 

Hugh: Exactly, cool. Well, that's a good discussion. Alright, thanks.

Walter: See you.

Hugh: All the information in this podcast is for educational and informational purposes only and is not trading or investment advice.

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