# Our Blog

## Heuristics in Trading Pt. 2

Representativeness

Representativeness: Used when making judgments about the probability of an event under uncertainty.
Representativeness at its core is overshooting the accuracy of a prediction because of the situations similarity to something else that you would expect to happen. This process usually includes disregarding any statistical evidence of its likelihood. It is the natural stereotyping of people and situations that our brain does in order to keep information tidy and coherent.Let’s examine an example of the representative heuristic.

Tony is an above average size male, twenty six years old. He is good at working with his hands, and enjoys the outdoors. Tony would be described by many as a “man’s man”.
When guessing what he does for work, would you say it is more likely that he works as a Motorcycle Mechanic or as a Retail Salesperson?
The intuitive answer to this question would be that Tony is a motorcycle mechanic. The image in our mind of a strong young man fixing motorcycles, most likely an avid rider himself, fits much better than imagining him standing in the showroom of a clothing store.The problem with jumping to the conclusion is the disregard of statistical data. As of 2012, it is reported that there are 16,800 Motorcycle Mechanics in the United States. The same report says that there are 4,447,000 Retail Salespeople in the United States. The likelihood that Tony is in Retail Sales is substantially larger. As stated above, our minds tend to disregard statistical evidence in order to form a coherent story. In Tony’s case there was no real information in his description that would lend to his working in one field or another. In cases like these the best course of action is to simply look at the highest probability, ignoring your intuition, and go with that answer. Over a large enough sample size you will be correct far more often than not.How Representativeness plays a role in Trading

While trading, the urge to make intuitive assessments of future and current price action is incredibly strong. It takes an amazing amount of discipline to ignore these feelings when they arise. As a Trader, how many times have you done careful research to define the direction, but ended up trading the opposite way because of an overwhelming intuitive feeling? These hunches are usually followed by a negative trade when the market pushes the way you had originally thought it was going in the first place. Oh, you also sacrificed the best entry because you second guessed your original assesment. Merely thinking “there is no way this can push further” is part of the representativeness heuristic. Of course it can push further. The reason we think it won’t is because we have seen a visually similar move at some point that did not push further, which most likely has nothing to do with this current push in the market. While staring at the charts they can take on amazingly similar setups all the time. The representative heuristic is meant to speed up the process in which we make decisions. This works wonderfully in the real world, classifying dangerous and favorable situations quickly, however in trading it can put you into the wrong trade at the worst possible price. The Forex Market takes on countless patterns that are seemingly recognizable. With a relatively small amount of screen time you can start making “intuitive calls” about future price action. This is especially true for a beginner trader. A beginner will be taught a certain way and follow it because they have nothing else to go off of, leading to what many would describe as “beginner’s luck”. Once they have watched price action enough they begin to make their own intuitive judgments and take negative trades because of them. How to disarm the Representativeness heuristic

To keep this heuristic from wreaking havoc on your trading account is by engaging your conscious decision making process. Checklists can be a massive help, as well as writing down the actual direction you suspect the market to run in. If the market is similar to the case of Tony (looks coherent but is lacking real information), the best course of action is to simply wait for more information to reveal itself. None of this is to say that there is no room for intuitive judgment. Intuition is your subconscious mind searching memories for information relevant to the situation, then feeds it to you in a “feeling”. Consider this: Research shows that it takes a Chess Master seven years of playing chess five hours per day to reach the highest level of intuition of the game. That is 12,775 hours of active concentration on a game of chess. This allows them to look at a chess board and quickly come up with many possible counters (some of them creative) to an opposing player’s position.
While there is hope to have a true Master’s intuition on the Market, it takes an awful lot to get there. In the meantime we can simply compile a well thought out list of things we are looking for and make our own “magic intuitions” on the market. By keeping your intuitions under control before they are refined, you can drastically increase your chances of making profitable trading decisions over a large sum of trades. As always, I encourage anyone reading this to do your own research into the subject and form your own viewpoints of these subjects.
There are still many other heuristics that come into effect while we are trading. Be sure to subscribe so you can be one of the first “in the know”.
-Shane Guth

Director of the Smart Money Course
shane@fx365i.com