In my last post, I sketched preliminary ideas regarding a cognitive theory of trading performance. One important implication of such a theory is that declines in the performance of traders and portfolio managers may not simply reflect "discipline" problems in the face of emotional pressures. Rather, a host of internal and environmental factors may conspire to shift market participants out of their optimal modes of processing information.
How does one generate an idea for trading or investment? I propose that this is a two-step process in which observation and analysis is followed by consolidation and synthesis. In the ideal trade, a number of observations relevant to markets and market participants come together and crystallize as a core idea or theme. Traders are familiar with the feeling of "rightness" that accompanies a gratifying synthesis: suddenly, out of the welter of data, there is clarity. It all comes together, and the trader experiences an intuitive "feel" for what is likely to happen.
Readers will recognize this as a creative process, not unlike the creativity of scientists. After many observations of nature, a scientist will generate a model that is the basis for a theory. Many times, this model will spring from an insight derived from an analogy. The behaviorist B.F. Skinner, for instance, drew upon evolutionary thinking to explain how reinforcements select for certain behaviors and not others, resulting in learning.
The "models" created by traders may not be so elaborated or even conscious. They can take the form of an image of what is likely to happen or an idea of a theme integrating recent observations. We build such models according to our native modes of information processing. In each case, however, the model-building--the idea generation of the trader--is a synthetic process. It may unite fundamental information, information derived from price and volume, information from related markets, recent news, or some combination of the above. Synthesis is a fundamentally creative process, because it extracts fresh order and meaning from what is given.
Problems can occur in trading at many points in this analysis/synthesis process. We can fail to make market observations, simply out of an impulsive need to trade. We can make those observations, but then fail to make the shift to a mindset that facilitates synthesis. Many active traders underperform because they act before observation/analysis has an opportunity to crystallize in a creative insight.
An interesting article summarizes research into some of the factors that facilitate and interfere with creativity. One important conclusion from this work is that fear and time pressure hinder the creative process. "Time pressure stifles creativity because people can't deeply engage with the problem," the article notes. "Creativity requires an incubation period; people need time to soak in a problem and let the ideas bubble up." The competitive, fast-paced conditions that are present in much of the trading world don't naturally lend themselves to incubation. The active mindset needed to gather observations may not be the mindset necessary for integrating those observations into market insights and unique trading ideas. Traders, after all, can only be as good as the ideas they act upon.
More on this topic in the next post in the series.