Psychological Mistake #4: The Appeal Of Sophistication

Many aspiring traders are incessantly chasing after some secret formula or “Holy Grail” in Forex trading. The need for sophistication is rooted in our culture, simply because the world naturally gives more respect and value to advanced or supercharged things. In scientific endeavours, complexity is certainly inevitable, as these are dealing with the elaborations of the physical world.

However, in the context of investment and trading, we are dealing not only with the markets, but primarily with ourselves! As such, much of the complexity in analyzing the markets often cloud our perception of our own psychology when trading the markets. As a result, we are naturally driven to be always looking out for new and advanced trading systems. The truth is that this phenomenon will never end. In order to be successful in Forex trading, we must focus our mental energies on the things that really matter.

The simplest trading rules can be the hardest to follow, but can lead to long-term profitability if the trader looks at the big picture and thinks in terms of long-term probabilities. It is amazing how the human psychological tendencies have sabotaged the trading results of many aspiring traders. Overcoming these tendencies is really far more important than devising complex techniques of selecting the “ideal entry points”.

The world we live in thrives on complexity. This is why the world of employment rewards those who can perform the most complex tasks with the most complex systems of knowledge, skill and expertise. However, in order to be able to trade the Forex market successfully, we need to clear our minds of the clutter of sophisticated concepts, which often blind us from the true nature of market bahaviour.

Many aspiring retail traders feel that it is certainly better and “smarter” to entrust their wealth management plans to investment professionals by investing in mutual funds, simply because these sophisticated professionals are supposed to know better what to do with their money. However, very often we do not realize that the ways in which their funds are operated are not designed to help investors make money. For example, a lot of equity mutual funds allow only long positions, and are mandated to be almost 100% invested all the time. This makes them totally dependent on bullish stock market conditions in order to generate wealth for the investors.

These funds are also often constrained by policies which are not beneficial to the investors. In fact, fund managers often get paid bonuses despite losing money, simply because their losses happen to be less than the benchmarks that measure their performance. The point is that we are often not better off entrusting our investments to sophisticated professionals, because investment success is often not about sophistication, but about mastering the psychology of trading or investing the markets.

Prior to the advances of computer technology, market prices were quoted through very primitive means such as scribbling on chalkboards and ticker tapes. In essence, market prices are really the results of millions of trading decisions. Every "tick" in the market prices are essentially the combined impact of these simultaneous trading decisions at one point in time. In the past eras, when there were no complex computerised representations of market data, some of the traders were able to master the ebb and flow of market movements and ride strong trends profitably.

In recent decades, advances in computer technology have given us many tools to help us better visualize the ebb and flow of crowd psychology. Different visual representations of market price movements have given rise to all kinds of analysis methods.

In the diagram below, we can see that the moment-by-moment impacts of trading decisions by traders all over the world can be represented as a series of price data items at various time intervals. As such, we always talk about the high, low, open and close (last) prices within every time interval. The table below shows minute-by-minute changes in these 4 basic price items.

These numerical data items can also be graphically represented on a 2-dimensional chart. The chart below shows a series of candlesticks, each of which is a pictorial representations of price data. As a result, the succession of blue and red candlesticks gives a more visual depiction of market trends.

To help us improve our analysis, there have been a lot of technical indicators being used by technical analysts. Each of these indicators is really based on some calculations involving historical price data. In fact, there are endless possibilities as to the number of indicators that can be "invented". Experienced traders seem to enjoy cluttering up their charts with all kinds of colourful lines, as illustrated in the diagram below. Somehow, many of them believe that their success in trading the Forex market is largely dependent on discovering more and more new indicators.

In essence, there are really no new inventions. The basic ingredients of all these technical indicators are always the same, i.e. the historical prices of high, low, open and close. These visual representations of crowd psychology are meant to help us improve our analysis and forecasts of market trends. However, in many cases, traders get excessively caught up in the increasingly complex web of indicators, and lose sight of the basic picture, i.e. many traders forget that it is the ebb and flow of crowd psychology that is driving the market, not the indicators. No matter how many fanciful and sophisticated indicators we can devise, the market is never obliged to behave according to the indicators. The basic and simple reason is that indicators are always based on historical data which are "lagging" and we have no access to "future data".

Make no mistake about this. There is certainly a lot of value in good technical analysis, but only if we use the indicators with the right mindset. With proper risk control, certain combinations of indicators can be used and fine-tuned to display appropriate levels of responsiveness to the onset of strong market trends, with decent probabilities of identifying winning trades. It is important to understand and acknowledge that no indicators or strategies can ever predict what will happen to the market. This is why planning for losses is so vital to the trading success of any trader.

There are many traders who enjoy seeking after complexity and sophistication, and easily disregard strategies which sound too simple. The underlying belief is that "If we don't understand it, it must work!" As such, they love to have their charts appear very colourful and cluttered with fanciful lines and indicators. It is almost as if they believe that the more lines they plot on their charts, the more equipped they are to make money from the Forex market. However, the irony is that many traders can trade profitably with only 1 or 2 indicators, or sometimes even none at all, on their charts. The fact is that successful Forex trading very much involves being "pure at heart and clear-minded", i.e. not allowing too many suppositions to cloud judgement of the market. Such a mindset involves the following elements:

• We are not overly concerned with predicting the future.
• We are not excessively influenced by past market behaviour.
• We are merely concerned with the present, i.e. what the market is telling us now, and respond according to a valid trade idea, with the necessary exit plans and risk control measures.

It is important to note that advances in computer technology and sophistication of analysis methods have not improved the success rates among traders around the world. Over the centuries, ever since capital markets appeared in human civilizations, we have always seen the same psychological tendencies among traders and investors. Things have certainly become much more sophisticated. Yet, we still find that most traders and investors lose money in all kinds of markets. The fundamental reason is that human psychology never changes. Unless we make committed and consistent efforts to overcome them in our trading behaviour, we are likely going to be among the majority of traders who get beaten by the markets.