In Daniel Kahneman’s book Thinking, Fast and Slow, he points out that the human mind employs two different and complementary thinking methods, System 1 and System 2. Each has its own virtues, but when it comes to trading, they tend to produce vastly different results.

We use System 1 to make snap judgments. System 1 is “automatic, frequent, emotional and stereotypical,” whereas System 2 is much more deliberate, logical and calculating.

System 1, the basis for discretionary trading, relies on intuition and rules of thumb.  For a professional trader, these two factors are resources that add color, but for aspiring traders intuition and snap judgments mostly lead to operator errors. You find yourself in a trade before you consider all the options, and especially before you consider you could be wrong. That means you have probably forgotten to set a stop or if you have set one, it’s provisional.  

Kahneman points out that when we find ourselves at a crossroads, once a plausible idea comes to mind it is very difficult to override it. At this point, the trader becomes committed to a course of action. If the market suddenly reverses, due to decisional inertia the trader is likely to act like a deer in the headlights, or worse.

Paradoxically, over-relying on System 1 plagues both novices and experts alike. Think about it. If you don’t know what you don’t know, you might believe the first thing that comes to mind. On the other hand, if you think you know everything, then your snap judgments will have a lot of conviction (and ego) behind them.

Here’s the key quote:    

 “Experts are uniformly inferior to algorithms in every domain that has a significant degree of uncertainty or unpredictability, ranging from deciding winners in football games to predicting longevity of cancer patients. One has to accept financial markets are no exception to the rule.” 
Daniel Kahneman

Bottom line, be aware of how easily and quickly System 1 offers you its opinion, as if it were a near certainty. Don’t be fooled by its confidence. Your thinking style should serve your method and not the other way around. Use System 1 judiciously to enhance the execution of your model, like a pilot trimming the flaps, rather than to invent/adjust the model on the fly.

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