Random Reinforcement: Why Most Traders Fail

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Random Reinforcement: Why Most Traders Fail

Random reinforcement is an intriguing growing concept in trading. Random reinforcement in trading happens when a trader incorrectly correlates a random result to their own ability or lack thereof. This may be harmful because a trader may grow to believe in their own brilliance when it does not thereā€”or drastically underestimate it when it does exist.

Key Takeaways

  • The attribution of random occurrences to qualify (or invalidate) some theory or notion; creating the appearance of expertise or lack of skill to an unsystematic result.
  • Random reinforcement happens when traders are paid (at random) for actions that they did not initiate.
  • Due to random reinforcement, traders may become overconfident in their abilities, even if this is objectively untrue.

How Random Reinforcement Affects Us

Because of unpredictability and noise, the market periodically rewards poor behaviors while punishing good ones. This is particularly dangerous if a rookie trader wins on a few early deals with no strategy and attributes their success to intrinsic talent or “intuition.” Random reinforcement may also be detrimental to seasoned traders who have had a streak of losses and think they no longer possess their genuine talent.

Random reinforcement may lead to long-term poor behaviors that are difficult to stop. It’s comparable to gambling addicts who keep playing because they win just enough to keep them there, but they’re losing money in the long term. A skilled card counter may also suffer a substantial depletion, forsake a tried and true technique, and therefore give the house the advantage.

For some traders, the notion of random reinforcement is difficult to comprehend, yet knowing it might be the difference between genuinely progressing as a trader and merely assuming we are when we are not. The simplest way to grasp this is to look at some instances.

Example 1: Relying on Randomness

Alex is a new trader with a business background who follows the stock market and monitors the news, but has never traded directly. Still, Alex believes they have what it takes to be a competent trader, but has yet to write down any techniques or trading approaches. Alex has started a trading account and feels that his prior knowledge will help him generate money. When Alex first opens a price chart, he notices a pre-populated stock ticker provided by default on the trading platform, and the prices are rapidly rising. Alex buys 200 shares of the default stock without even thinking about it. During lunch, the stock continues to increase. Alex returns after lunch and sells the shares for a $100 profit after fees. Alex makes another deal and achieves a similar outcome, gaining confidence and developing a “knack” for trading.

  Introduction to Stock Trading

When assessing the issue, experienced traders will identify a few elements that might lead to this trader’s trading career being cut short. The fundamental issue is that a few successful transactions are not a reliable indicator of whether a trader will be lucrative in the long term. Alex, the trader in this scenario, must be careful not to fall into the trap of assuming that present approaches, which are still in their infancy, can provide long-term success. The risk comes in denying good market direction or procedures, whether self-created or offered by someone else, since this preliminary untested approach is thought to be better based on these early transactions. The trader may tend to believe that if it worked once, it will work most, if not all, of the time. Over time, the markets will not reward erroneous reasoning, but they may reward haphazard and unplanned transactions.

In the next example, we will look at random reinforcement from a different perspective. This example is more applicable to experienced traders or traders who are entering the market with a documented technique or approach that has been back-tested or demonstrated to be lucrative in live trading. It should be emphasized that not all approaches that have been effective in the past will continue to be successful in the future, as we saw in the prior case (on a small scale).However, procedures that have previously shown success are more likely to give a prospect of profitability in the future than ways that are wholly untested or have never been lucrative in the long term.

Example 2: Abandoning a Sound Strategy

Alex has now been trading for some time and recognizes that going into the market without a well-thought-out, detailed, and carefully studied strategy was a mistake. The initial issues highlighted in the first example have been resolved, and a good trading strategy for accessing the markets is now in place. Over the last two years, this new, disciplined strategy has shown to be effective and profitable.

  Trading Skills

Alex, on the other hand, is now dealing with a new issue. Despite previous success with this method, it has now resulted in nine straight loss transactions, raising concerns that the strategy is no longer functioning. As a result, Alex modifies the trading strategy hurriedly, believing that the previous approach is no longer applicable. As a result, Alex ends up trading a new unproven strategy, making similar mistakes as in the beginning.

The issue in this case arises when Alex abandons the tried and tested strategy, which has proved to be effective, in favor of an unproven alternative. This might send Alex back to square one, despite the fact that he has been trading effectively for many years.

What caused this to occur? Alex failed to see that, although chance might produce winning streaks with a weak trading strategy, it can equally produce a run of losses with an outstanding trading strategy. As a result, it is critical to ensure that a trading strategy is no longer viable (was the first success random?) or decide if this is merely a run of losses caused by present market circumstances that will pass shortly.

All traders lose money, and there is no set amount of losing transactions in a succession that will notify a trader whether their strategy is no longer functioning. Each technique is unique, but we can all learn to live with unpredictability.

Frequently Asked Questions

Why does random reinforcement happen?

Humans are pattern-seekers by nature. However, the world as we know it is full with unpredictability, which the human brain dislikes. At the same time, individuals want to feel in control of their own fate and self-determination. As a consequence, when random occurrences occur, individuals are prone to misattributing them to something they have done.

How does random reinforcement influence traders?

Random reinforcement presents itself in two basic ways among traders. The first is that it might offer inexperienced or unskilled traders a false impression of aptitude when previous favorable results were solely due to chance. The second way that a streak of poor luck might cause an otherwise experienced practitioner to question their competence and forsake a sound plan is via a string of terrible luck.

  Trading House Definition

How can one protect against the negative biases of random reinforcement?

Once we understand that randomness may produce strings of losses in excellent trading tactics and strings of gains in terrible trading methods (as well as situations in between these examples), we can adapt appropriately. Each trader should have a documented trading strategy that describes how and when transactions will be made. This strategy should be well-researched and explicitly define entry, exit, and money-management principles. In this method, the trader will know in the long term if the strategy is defective or effective based on objective criteria. It is also critical to risk a modest amount of capital on each individual transaction; risk limits for each trade should be included in the trading plan’s money management section. This allows the trader more discretion since they will be able to suffer a streak of losses and will be less prone to modify their trading strategy when it is not necessary.

The Bottom Line

The markets are incredibly dynamic and constantly changing. This introduces an element of unpredictability, which may result in wins for inexperienced traders and losses for experienced traders, and it occurs all the time. A trader must also distinguish between when a particular streak of losses or gains may be attributable to their competence and when it is random.

While you are learning, the best way to achieve this is to approach the markets with a trading strategy and risk a tiny amount of your cash on each transaction. In this approach, the trader may evaluate how a strategy performs over time, when unpredictability becomes less important. It is also crucial to note that even the greatest traders and trading strategies have losing streaks, which is not a cause to quit the approach. However, determining why the strategy is no longer functioning may assist reduce the magnitude of the losses if comparable unfavorable situations occur again.

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