The Psychology of Trading | Brett N. Steenbarger

Summary of: The Psychology of Trading: Tools and Techniques for Minding the Markets (Wiley Trading)
By: Brett N. Steenbarger

Introduction

Dive into the complex world of decision-making with the book summary of ‘The Psychology of Trading: Tools and Techniques for Minding the Markets’ by Brett N. Steenbarger. Explore the factors that influence our choices, including context, selective perception, cognitive dissonance, and flawed memory. Discover the role of heuristics and biases in our judgments and the history of decision theory. With this summary, gain a deeper understanding of the psychological processes behind our choices, as well as ways to improve decision-making by considering alternative perspectives and minimizing biases.

The Psychology of Decision-Making

In a world where we’re faced with endless choices, making the right decision can be overwhelming. However, psychology researchers have conducted numerous experiments and studies to understand how humans make decisions and have some recommendations on how to make better ones. First, understand that the context of every decision matters. A famous card experiment demonstrated that selective perception can cloud our judgment. People’s decisions are also swayed by the way questions are framed. To avoid psychological inconsistencies, it’s crucial to elicit judgments in various ways. The book uses a parable to emphasize the importance of consistency in one’s motives. The tailor’s shop incident showed that when the motivation changed from hatred to monetary rewards, the hooligans lost interest in taunting the Jewish tailor. Understanding these psychological principles is crucial for better decision-making and can lead to a happier life.

The Fallacy of Memories

Memories are fallible, and context plays a crucial role in decision making as well as memory formation.

Have you ever been certain about a past event, only to discover that your recollection was incorrect? Memory is fallible and can interfere with logical, emotion-free decision making. Memories are not mental copies of our previous experiences; instead, they are mental reconstructions of past events. We often reconstruct our personal histories inaccurately. Research has shown that memories can be inconsistent with actual past events. So, it is important to keep good records to avoid this pitfall.

Context also plays a crucial role in memory formation, which affects all human perceptions. For instance, real estate agents know that contrasting a home positively against another home that requires a lot of work or is too expensive can make it more appealing. In decision making, situation-specific factors such as time availability and mood influence judgment and decision making significantly.

Even when answering mundane questions, context can significantly impact one’s responses. In one experiment, researchers asked college students to rate the degree of unity among fictional citizens of various nations. Surprisingly, four out of five students confidently gave their opinions on how closely these people felt towards their fellow citizens, despite the fact that these characters did not exist. Survey experts know that how questions are structured and framed can significantly affect responses. Therefore, it’s essential to keep the order of questions and words in mind when considering survey results.

In conclusion, memories are fallible, and context plays a crucial role in decision making as well as memory formation. It’s vital to keep these factors in mind while making decisions and interpreting the accuracy of survey results.

Principles of Rational Decision Making

This summary explores the history of decision theory from its early beginnings with mathematicians Nikolaus and Daniel Bernoulli to Leonard Savage’s “subjective expected utility theory.” The authors refine Bernoulli’s “expected utility theory” to derive six principles of logical decision making. They include the “ordering of alternatives,” “dominance,” “cancellation,” “transitivity,” “continuity,” and “invariance.” The principle of “stochastic choice” proposed by Duncan Luce in 1959 treated choices as probabilities and introduced randomness as a factor influencing decision making. Lastly, prospect theory proposed by Daniel Kahneman and Amos Tversky in 1979, incorporates loss aversion as a significant factor in decision making. Despite numerous attempts by other researchers to supplant expected utility theory, it remains the primary concept in decision making. The article concludes that for rational decision making, individuals must consider these principles along with objective facts and subjective probabilities.

The Biases in Decision Making

Heuristics are general rules that people use in decision making, and while they can save time, they can also lead to biased thinking. One such bias is the “representative heuristic,” which assumes one choice stands in for another. The “availability heuristic” concerns an event’s probability based on how common or frequent it appears. These biases have important consequential effects, such as making us less inclined to live healthier lifestyles. To counter these biases, we can keep accurate records, ask for third-party assessments, and avoid wishful thinking.

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