Given the prevalence of decision making in trading/investing and our great ability to sabotage our decision making with psychological biases, I think having few structured techniques in our toolbox for good decision making is highly useful.
The purpose of this post is to put forth the idea of utilizing structured decision making techniques available in other fields in trading and to present an overview of 5 simple and effective decision making techniques.
Technique - 5 WHY's:
This is a pretty powerful technique that allows one to quickly identify the hidden reasons behind a poor decision or trade. Often the reason turns out to be a human error. The technique was originally developed and was used within the Toyota Motor Corporation during the evolution of its manufacturing methodologies.
- Look at the problem and ask "Why?" and "What caused this problem?"
- Very often, the answer to the first "why" will prompt another "why" and the answer to the second "why" will prompt another and so on;
- Do the above up to 5 whys. Hence the name the 5 Whys strategy.
- The vehicle will not start. (the problem).
- Why? - The battery is dead. (first why)
- Why? - The alternator is not functioning. (second why)
- Why? - The alternator belt has broken. (third why)
- Why? - The alternator belt was well beyond its useful service life and not replaced. (fourth why)
- Why? - The vehicle was not maintained according to the recommended service schedule. (fifth why, a root cause)
- Change habit and start maintaining the vehicle according to the recommended service schedule. (possible 5th Why solution)
For traders - To get more out of the technique, one approach is to take past 5 trades or decisions that were not satisfactory and apply this technique on each of those trades. Then look for patterns in your answers. I believe this is one of the fastest ways to shine light on hidden/subconscious patterns that sabotage one's trading.
Note: The 5 Whys strategy is an easy and often-effective tool for uncovering the root of a problem. Because it's simple, one can adapt it quickly and apply it to almost any problem. Bear in mind, however, that if it doesn't prompt an intuitive answer, then don't push it and you may have to use another technique.
Technique - FORCE FIELD ANALYSIS:
This technique helps you make a go/no-go decision quickly by analyzing the forces for and against a change (or trade), and it helps you crystallize the reasoning behind your decision. You can use it for two purposes:
- to decide whether to go/no-go with the change; and
- to increase your chances of success by strengthening the forces supporting change and/or weakening those forces against it.
- To carry out a Force Field Analysis, describe your plan or proposal in the middle of a piece of paper or whiteboard.
- Then list all of the forces for change in a column on the left-side, and all of the forces against change in a column on the right-side.
- Next, assign a score to each force, from, say, 1 (weak) to 5 (strong), and then add up the scores for each column (for and against). You can then decide whether or not to move forward with the change i.e., no go if favor score is less than against score.
- Alternatively, you can use your analysis to think about how you can strengthen the forces that support the change and weaken the forces opposing it, so that the change is more successful.
Note: We cannot control markets. But we can control our leverage, combination of setups we employ and when/where we enter etc. For example, like trading only 1st pullbacks vs trading all pullbacks or having low correlated setups in portfolio etc.
Technique - PARETO ANALYSIS
This is a statistical technique used for selection of a limited number of tasks that produce significant overall effect. Most already would know this as the "80/20 Rule" – which is the idea that 20% of causes generate 80% of results. Applying this technique in a structured fashion helps well to find the 20% of work that will generate 80% of the results that doing all of the work would deliver.
Step 1: Identify and List Problems i.e., write a list of all of the problems that needs to be resolved.
Step 2: Identify the Root Cause of Each Problem i.e., for each problem, identify its fundamental cause. Techniques such as 5 WHYs, Brainstorming etc can be used for this step.
Step 3: Score Problems i.e., now we need to score each problem. The scoring method we use depends on the sort of problem we are trying to solve. For example, if we are trying to improve profits, we might score problems on the basis of how much they are costing or profits they generate.
Step 4: Group Problems Together By Root Cause i.e., for example, if three of our problems are caused by pulling the trigger too soon, put these in the same group.
Step 5: Add up the Scores for Each Group. The group with the top score is our highest priority, and the group with the lowest score is our lowest priority.
Step 6: Take Action i.e., now we need to deal with the causes of our problems. Deal with the top-priority problem, or group of problems, first. Low scoring problems may not even be worth bothering with i.e., solving these problems may cost us more than the solutions are worth.
Note: While this approach is great for identifying the most important root cause to deal with, it doesn't take into account the cost of doing so. Where costs are significant, one need to use techniques such as Cost-Benefit Analysis or Weight the scores above as a function of cost.
Technique - OODA LOOP:
The OODA loop (for observe, orient, decide, and act) is a concept originally applied to the combat operations, often at strategic level in military operations. It is now also often applied to understand commercial operations and learning processes. This technique is especially useful when you are in a trade or for managing an existing decision towards a favorable outcome.
Observe: At this initial point in the loop, we should be on the look-out for new information, and need to be aware of unfolding circumstances. The more information we can take in here, the more accurate our perception will be.
Orient: One of the main problems with decision-making comes at the Orient stage: we all view events in a way that's filtered through our own experiences and perceptions. Boyd identified five main influences - Cultural traditions, Genetic heritage, Analytical ability, Previous experience and New information coming in. Orientation is essentially how we interpret a situation. This then leads directly to your decision. And it's important to remember that we are constantly re-orienting. As new information comes in at the Observe stage, we need to process it quickly and revise our orientation accordingly.
Decide: Decisions are really our best guesses, based on the observations we have made and the orientation we are using. As such, they should be considered to be fluid works-in-progress. As we keep on cycling through the OODA Loop, and new suggestions keep arriving, these can trigger changes to our decisions and subsequent actions – essentially, we are learning as we continue to cycle through the steps. The results of our learning are brought in during the Orient phase, which in turn influences the rest of the decision making process.
Act: The Act stage is where we implement our decision. We then cycle back to the Observe stage, as we judge the effects of our action. This is where actions influence the rest of the cycle, and it's important to keep learning from what we, and our opponents (market), are doing.
Technique - PORTER's FIVE FORCES
Porter's Five Forces Analysis is an important tool for assessing the potential for profitability in any industry and where the balance of power lies. With a clear understanding of where power lies, we can then take advantage of a situation of strength, improve a situation of weakness, and avoid taking wrong steps. This makes it an important part of planning toolkit. With a little adaptation, it is also useful as a way of assessing the balance of power in more general situations.
Porter's Five Forces works by looking at the strength of five important forces that affect competition:
- Supplier Power: The power of suppliers to drive up the prices of your inputs.
- Buyer Power: The power of your customers to drive down your prices.
- Competitive Rivalry: The strength of competition in the industry.
- The Threat of Substitution: The extent to which different products and services can be used in place of your own.
- The Threat of New Entry: The ease with which new competitors can enter the market if they see that you are making good profits (and then drive your prices/edge down).
By thinking about how each force affects you, and by identifying the strength and direction of each force, you can quickly assess the strength of your position and your ability to make a sustained profit in the industry. You can then look at how you can affect each of the forces to move the balance of power more in your favor.
For example, if a retail trader is considering high frequency trading or trading on very low time frames, it is helpful to apply this technique and see how their current ability stacks up against well funded HFT hedge funds and prop firms. Similarly for a retail trader considering fundamental analysis as the primary approach, it is helpful to consider how their current ability will stack up against funds that employ army of full time analysts or ex-CEO's who has been in that field. One can say similar about trader pursing Technical Analysis i.e., how does their current ability stack up against thousands of others who also read same or more books on trading. Just to be clear...I am not saying a retail trader cannot compete. What I mean is a trader before employing any strategy should know clearly what their edge is to survive and thrive before getting into water to play with sharks.
There are many other decision management techniques one can use like PEST, SWOT, Risk Management Techniques etc. Nearly every aspect of trading require us to look directly into eyes of uncertainty and make decisions while battling our biases. To me the biggest advantage of using these decision making techniques are to provide consistent structured decision making process and a first level of defense against decision traps (our psychological biases).
I hope you enjoyed this post and found few things to investigate further for your use. Year end is a great time to reflect where we have been, how we did and where we want to go. Also a good time to leave the past behind, spend more time with loved one and move into new year carrying with us the lessons earned and happy memories.
I wish you and your families good health and a happy new year!!!
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