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The fire commander who "knew" something wasn't right

Daniel Kahneman is a psychologist and nobel laureate. He, along with his deceased colleague Amos Tversky, has published many notable works on the psychology of judgment and decision making. He is one of the initiators of the theories and ideas used in behavioral economics, including prospect theory which questions rational decision making in all aspects of life, including the markets (and trading). His most recent publication, THINKING FAST AND SLOW is directed towards the layman, not the researcher. Kahneman describes two ways in which our brains think.....fast, or intuitive, and slow or rational and logical.

These two methods of thought have been recognized for decades, if not centuries, but what Kahneman and Tversky did was to examine the "fast" way of thinking much more specifically. The two researchers brought to the attention of psychologists the fact that humans have developed extraordinary capabilities, but that these have come at a price. We use heuristics to guide us in our decisions. The subconcious mind is capable of both amazing understanding and decision making, and unusually poor judgement in other areas, when we do not see the bias that has developed with time. In Thinking fast and slow, Kahneman states that his objective is to "improve the ability to identify and understand errors of judgment and choice, in others and eventually in ourselves."

Kahneman retells a story that Gary Klein (author of sources of power, a great book about thinking and decision making) has described about a team of firefighters that entered a house in which the kitchen was on fire. They were using their firehoses to extinguish the blaze, which was not responding. The commander shouted "let's get out of here," not knowing exactly why they should get out, but knowing with certainty that they should. As the firefighters leave the house, the floor collapses. It turns out that the fire had not begun in the kitchen, but was in the basement. As he later thought through the situation, the commander realized that the blaze was "hotter than usual" and that the fire had not been responding as expected. The fire was also "quieter" than typical. These things caused him to realize that something was not right. When he made the decision to get out of the house, he did not realize why he felt this way, he simply knew he did.

In my trading essentials section of this website, I relate the importance of experience. It is crucial to being a good trader. I tell the story of a radar officer confronted with a difficult decision during the Persian Gulf War. I will recount it here. This comes from one of the books described in the book review section.

Near the end of the Gulf War a British Destroyer the HMS Gloucester, was patrolling in the Persian Gulf. The ship was twenty miles off the coast of Kuwait, near Kuwait City. Around 5:00 am Lieutenant Commander Michael Riley, the anti-air warfare officer, spotted a radar contact over the Gulf. The contact was in the location of the enemy silkworm missiles, the location of which was known by the allied forces. Unfortunately American A6 fighters were performing bombing runs in the exact same area, and though they had specific routes that they were supposed to follow, the American pilots were known to cut corners and travel the exact same route as this specific radar contact. In addition, the American A6 is about the same size as the silkworm, and the A6 traveled at about the same speed as the silkworm on return to the carriers. The Gloucester had recently moved closer to shore, and the American planes had not yet taken that position change into account and were routinely flying over the ship. Officer Riley had insisted that this practice be ended, but so far his demands had not caused the pilots to change course.

Add to all this uncertainty the fact that only a few years earlier the USS Vincennes had, in the same vicinity, fired two missiles which destroyed a commercial airliner , Iran Air flight 655. Clearly, Officer Riley had a lot to consider as he pondered the radar blip that he encountered that fateful morning.

Officers who reviewed the incident later, testified that there were four ways to distinguish an American A6 from a silkworm missile. The first is location and we have seen from the routes that the A6's were flying that location would not help. The second is identifiable radar, which the American planes were equipped with, but which most of the pilots were known to avoid using since it allowed for easier detection by the enemy. The third way is a special system IFF (identify friend or foe), but again the American pilots did not use this system in enemy territory because it could become a homing beacon for hostile missiles. The last way to distinguish the American planes from the Silkworm was by altitude. Unfortunately the Gloucester's 992 and 1022 radars had no altitude capability. Only after a possible target is noted, is the Gloucester able to use the 909 radar to give horizontal, or altitude data. This takes approximately 30 seconds to gain altitude information. As fate would have it, on this occasion, the weapons director failed on the first two attempts to get altitude information on the radar contact (Errors were made in typing in the track number), thus our lieutenant had no altitude data with which to make his decision........a decision that was made forty seconds after first contact was noted. (Think about that.....a maximum of forty seconds to process the information and decide what to do)

After watching the radar blip approach his ship for those forty seconds, Officer Riley fired two missiles. He was certain that the blip represented an enemy silkworm. When the radar blip is hit and destroyed, voice data reveals the captain of the Gloucester responded "Whose bird was it?" (The captain was inquiring as to who shot the missiles that destroyed this unknown track). Riley responds "it was ours sir".

It took four hours for the Gloucester to verify that the blip that was destroyed ..........was in fact a silkworm, and officer Riley's actions had saved the ship.

This event and the exact manner in which it occurred has been detailed by Klein in "Sources of Power...how people make decisions". Experts interviewed Officer Riley, and reviewed the data recordings in detail. None was able to understand how Riley could be sure that the blip he shot down was a silkworm. But, from the beginning, Riley had insisted he was sure. In fact he said that he knew it was a silkworm within the first five seconds of contact. But he did not know how he "knew". The specific actions of all involved were reviewed with meticulous detail both by the Royal Navy, and by outside agencies. For the longest time, most of those reviewers felt that Riley had been lucky. They were sure that he in fact could not know with certainty what he claimed to know, that the radar blip was a missile.

In the end a researcher named Rob Ellis was able to recognize that since the A6 generally flew at around 3000ft. and a silkworm would be more likely to be at around 1000 ft.; and since the radar on the Gloucester would recognize or "pick up" a contact coming off the coast at 3000ft more quickly than one at 1000ft.; he concluded that yes, Riley could have "known" what he said he "knew". It was this knowledge that saved his ship.

How was Riley able to know what he knew, without being able to elucidate how he knew?
Intuition.
This is not intuition as in something that he was born with, but rather simply an accumulation of knowledge that comes with extensive experience.

The actions of a trader undoubtedly do not carry the same implications as those of Lieutenant Riley. Nonetheless those actions must be made under quite similar time constraints, with extensive uncertainty. The only reasonable preparation for making decisions in such situations is extensive experience. The best traders have that experience.

Years ago I spent several days with Mark Cook trading at his farmhouse in Ohio. For those of you who do not know, Mark Cook has proven himself to be one of the great traders. There can be no doubt about that. Mark is a great guy, personable, and quite capable. The money I paid to trade with him, or rather watch him trade, was well spent. Mark stressed the importance of many things including a plan, a morning ritual, and most importantly of keeping records. He showed me row after row of journals of his that he had kept over years and years of trading. When I was with him, Mark told me of some of his favorite set ups for trades. He described in detail when he took the trade, and under what parameters he would end the trade. He had a plan. But on one morning he entered such a trade, watched it for a while, then exited the trade with minimal gain. I watched curiously because at the time he got out of the trade, he had neither met his stop, nor his profit objective. I asked why he had exited the trade and I remember like yesterday him turning to me and saying "it just didn't feel right". I grimaced a bit, tilted my head to the side as one does when trying to understand, and asked for more explanation, but there was none....."it just didn't feel right" was as good as it got. In the beginning, I hated this and felt as if there was little I could learn from such a comment. But now years later, I understand completely what was happening. Mark's intuition was telling him the trade was a loser. He did not consciously understand why, and certainly could not articulate why, but he "knew" nonetheless that the trade should be exited. That knowledge did not come from books, or mentors, but from thousands of days trading. New traders do not want to hear this, but it is true. Success at trading takes time, and as you try to develop the intuition necessary to trade well, you need to simply stay alive and limit losses in the learning period.

These examples give us some understanding of the rapidity and accuracy with which the subconcious mind can work to assimilate historical data from previous experience, compare that to a current situation, and then lead a decision. It is simply amazing.

Unfortunately, there are other aspects to this type of thinking that are somewhat less amazing.

Imagine you take off in a helicopter from Los Angeles. What is the true compass course the helicopter would fly to go to Reno, Nevada.

Draw a vertical line straight up from Caracas, Venezuela.....What major U.S. city does this intersect?

If you answered East, and Dallas or New Orleans, then you are like most of us.......Incorrect.

The true answers are 20 degrees WEST and BOSTON.

These answers are given by a majority of people to whom these questions are posed. They are intuitive, and yet they are wrong. Much like people asked to draw the boot shape of Italy, who most often fail to tilt the sole of the boot to the East, towards China, but instead give the shape a much more North to South appearance. This also is intuitive, but it is wrong. And yet most people who are asked answer in the same way.

What can we take from these examples and how can we apply that knowledge to Trading?

There are a couple of lessons to be learned here. First and foremost is that our brains are incredible calculators, able to compile, store, retrieve, compare data, and direct us, in milliseconds. But the brain has to be taught. We cannot come into trading and think we can use our "intuition" from early on and expect good results. Those of us new to trading simply have no reliable intuition. We must develop it.

Intuition is not something we are born with.............it is experience. It is a compilation of hours, days, months, years worth of repeated exposure in the field of our choice. For Tiger Woods, it is the ability to sense the climate conditions, the lie of the golf ball, the receptivity of the greens in an instant, and be able to choose the club and the force with which he will swing it; for Lebron James it is the ability to sense the court, the opposition, the movement of his teamates, and predict what and how he should react; for Yo Yo Ma it is the ability to move his fingers with the incredible precision required to convey his interpretations, no matter the setting and situation; for generals George Patton and Erwin Rommel, it was the ability to think one step ahead of his adversary, and be able to assess battle situations and responses in an instant. Intuition is experience, plain and simple. If you want to have it, you must put in the work. There is simply no substitution for hours and hours in front of a computer for a trader. You simply must have it. You may not recognize the benefit, but it is there, whether your trades are winners or losers. However, and this is very, very important, you must maximize the potential of your learning. You must keep records of some sort.....AND......YOU MUST REVIEW YOUR TRADES! Let me say that again, you MUST review your trades....winners, and losers!!! Doing this will shorten your learning time considerably. Just as importantly, NOT doing this will LENGTHEN that learning time. There is no substitution for hard work and this is part of it. You must work diligently to expose your mind to appropriate information, not just any information. You must write down what you were thinking when you made a trade, what you were thinking when you got out, what your plan was (if you had one) when you made your trade, and why or why you did not follow it. You must review this (however painful it may be) at a time when you are distanced from the trade and your mind can be open and receptive to such information. You must do this! There simply is no substitution. And when you do this, slowly, but surely, you will begin to develop the same type of intuition as the fire commander or the radar lieutenant commander.

Experience will sharpen our intution, that is the first lesson. But there is another lesson. Our minds can........AND WILL......play tricks on us, and we must not allow ourselves to be blind to that aspect of our subconcious minds. The most obvious example that comes to my mind with regard to trading, is the manner in which traders will completely lose objectivity when assessing a trade in progress. In other words, the trader with a stake in a situation will often filter new information in such a manner that he or she will give more weight to aspects that agree with or support his position, and less to those that do not support the position. I have seen it many times in my own behavior. In fact, in reveiwing trades I could often not believe that I missed the clues that the trade would fail. My subconcious had "failed" me. No one likes to be wrong, certainly not those with enough initiative and motivation and intelligence to pursue trading. But we must recognize that we will be wrong. There is no other way. And our minds will play tricks on us, our intution will decieve us. We must recongize and allow for that possibility, and incorporate a manner to deal with it in our trading. We have to pre define our trades, and expect to sometimes be wrong. We have to review our trades and recognize our deficiencies.

Intuition is a marvelous thing. It can be invaluable. But it must be recognized for what it is......a compilation of experiences. We must also recognize that each of us is subject to an intuition that has a bias. That bias, whatever it is, was developed over years and we will be blind to it, unless we look and look hard. Socrates said The unexamined life is not worth living. For the trader, nothing could be more true. If taking the time to review your trades, your reasons for entry, your plan, your reasons for following or failing to follow that plan, your exit, and everything about that trade is too tough for you............Find another passion.