Logic takes a back seat in share trading

Everyone knows the old rule about dumping your losers and letting your winners run. But many active share traders lose their bank within a year. Why is it so hard to be logical?

It's because logic is only part of the process.

Brokers say that not having a plan - or having a plan but not sticking to it - are the biggest problems. In techno-speak that is inadequate or biased perception, often followed by inadequate or biased analysis, followed by inadequate execution. In other words, often we can't see, can't think or can't do.

Can't see

It's about looking at the wrong information, seeing things that aren't there, because you really want to see them, or being blind to things you don't want to know about.

Many traders are fixated on seeing things that predict price changes. Even if this is possible, it might not be as important as doing the right thing when the price does change.

Can't think

Analysis problems include inadequate or incomplete data processing, not doing enough homework, or using biased data.

Also included here are common intellectual errors: rules of thumb, ignorance of money management or probabilities, and innumeracy.

Often novice traders' only early models are lotteries and other get-rich-quick schemes. This may lead to lack of diligence in investing.

Can't do

Even if we have enough of the right information, processed sufficiently for our purposes, action may not occur because of emotional factors.

Our well-known risk aversion is avoidance of potential punishment. All animals do this.

Selling a stock when it falls by a certain amount is counter to instinct. We are hardwired to be hopeful, and logic has very little to do with it.

Anyone who has said to himself, "I just know this stock has got to come up" with increasing levels of desperation, knows what I mean.

How does it happen?

Someone who has been intellectually successful but impulsive may analyse well but fail because they "jump the gun". Someone rapidly losing their bank may be desperate to claw back money, and get into risky positions.

Someone who has been burned may ask the opinions of friends, weighing that evidence more seriously than their own calculations.

Self-awareness is the first step in preventing these weaknesses. However, rationality is considered a superior faculty to everything else, and its impairment is regarded as a serious lapse. Emotions are regarded with suspicion, especially for men. Admitting vulnerability, even to yourself, is seen as weak.

Why is it so hard to be rational?

Because we are human, and humans are animals driven by habit, fuelled by reward and punishment, towards enterprise or caution. These habits evolved as ways of keeping us alive.

Expecting mechanical precision from human beings is foolish. Attempting to override millenniums of programming is a major challenge. The ability to compute moving averages, build spacecraft and understand cricket are relatively recent and sophisticated innovations.

We can't afford to underestimate the power of the inner primate. To solve the problem of rational trading we need to know, understand and work with the whole nature of the beast.