Strategic thinking matters
Different jobs require different skills. In finance, salespeople need skills that differ from those of research analysts or traders. Yet, if you look at the job qualifications employers look for, there seems to be a one-size-fits-all approach. All finance and investment jobs apparently require a high level of cognitive skills (i.e. the ability to think ‘rationally’) with a dash of positive behavioural traits.
A new study investigated if cognitive skills are really that important for one group of investment professionals: traders. They found that cognitive skills matter in school and at university where students with higher cognitive skills (i.e. higher ‘IQ’) outperformed students with lower cognitive skills. But when they invited 56 professional traders from the City of London to come to a lab at University College London for a series of tests, they found no relationship whatsoever between the trading performance of these people and their cognitive skills. Smarter people are not better investors nor are better investors smarter than the rest, as I have already explained here.
Similarly, there were no personality traits associated with trading success. Jerks weren’t more or less successful as traders, but they were definitely less pleasant to work with.
However, the researchers found one characteristic that correlated highly with trading success: the ability to think ahead strategically.
What does thinking ahead strategically mean? To explain this, we need to look at a famous guessing game often referred to as Keynes Beauty Contest. It goes something like this:
Each participant submits a number between 0 and 100. The number that comes closest to two thirds of the average of all submitted numbers wins.
If you think about it, this is quite a devious game. If every participant submits a random number between 0 and 100 you would expect the average to be 50. Thus, you should submit a number close to 2/3 * 50 = 33.3 to win the game. But if everybody thinks the same way as you do, other participants will submit a number close to 33 as well, so you should submit a number close to 2/3 * 33 = 22.2 to win the game, etc. If you think infinitely far into the future, you come to the conclusion that you should submit the number zero to win the game.
The problem is just that most normal people don’t think that far ahead. By playing this game with different groups of people, you can find out how strategic people are in their actions. The more steps they think ahead, the more strategic and long-term oriented these people are. Having said that, here is a list of people who played that game taken from this paper that shows that different professionals have different levels of strategic thinking:
CEOs: Average 37.9 (thinking 1.0 steps ahead)
US high school students: Average 32.5 (thinking 1.6 steps ahead)
Economics PhDs: Average 27.4 (thinking 2.6 steps ahead)
Global investors: Average 26.0 (thinking 2.8 steps ahead)
Portfolio managers: Average 24.3 (thinking 3.2 steps ahead)
Game theorists: Average 19.1 (thinking 4.3 steps ahead)
And how did traders fare in the study mentioned above? About one in five was thinking one step ahead while one in five chose a number between 0 and 1, thus showing an inclination to think many steps ahead. About half thought ahead several steps while 15% seemingly didn’t pay attention (let’s be generous here) and chose a number higher than 40.
But how many steps the individual traders thought ahead said a lot about their success as traders. The chart below shows the average trading profit in the lab experiment as a function of the number submitted by the trader. The more steps a trader thought ahead, the lower the number he or she would submit, but also the more successful this trader was at their job.
What matters for traders is to be able to anticipate the next market moves and the better they get at this, the more money they make. This gels nicely with an old study that showed that traders that are calmer in the face of market volatility tend to make more money. I think being calm in the face of adversity is only possible if you are prepared and have – at least to some degree – anticipated that volatility.
Trading success correlates with strategic thinking
Source: Angrisani et al. (2022)
Great post as always, but I am a tad wary of trading too far ahead as it can create a theses with far too many variables, and with that many failure points. Empirically I have found, thinking 3 steps ahead and trading 1.8-2.2 steps ahead (and no more) creates the best risk-reward ratio, with each confirmation step setting the ground for further trades down the road.
Incidentally the paper also seems to echo similar thoughts - "Effectively no one in this contest would need to think beyond two steps of reasoning, so even if players can, they are better off not doing so (i.e. avoiding the curse of knowledge)"
Saying there is "no relationship whatsoever between... trading performance.... and... cognitive skills" and then concluding that "trading success correlates with strategic thinking" is a blatant contradiction. Claiming on the one hand that IQ doesn't matter, and then turning around to say strategic thinking capacity is an asset, makes no sense. An individual with outlier-level ability to engage in strategic thinking has a significantly above average intelligence by definition, at minimum in that one area if not generally, which also fits the observation that there are many different types of intelligence. Either way, it's kind of silly to imply that being smart has no advantage and to then extol an edge that, on balance, is far more likely to show up in smart people. Cognitive egalitarianism in trading is akin to arguing that height doesn't matter in basketball. Being six-foot-eight doesn't mean you're an NBA candidate, but it sure as heck improves the odds.