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December 16, 2020

What is random reinforcement and how can it affect trading success?

Forex is now the world’s largest financial market and, according to data from the Bank of International Settlements, the daily trading volume has started to rise exponentially since around 2016. Major financial institutions make up for a large percentage of the market, of course, but they’re not the only force pushing it forward. Technology has made it possible for online trading platforms to thrive so that, apart from finance experts, regular individuals have started to trade occasionally, motivated by the desire to multiply their income. According to one report, there are now over 9.5 million online traders in the world, and, although the action continues to be centered around the New York and London hotspots, other regions are emerging too, particularly in Asia and the Middle East.

Compared to a few decades ago, we can now notice significant differences in the portrait of the modern trader. If, in the 1990s, traders were people in their 50s or 60s with a finance degree and experience in finance companies, now, the modern trader is more likely to be in their mid-20s, take their information from online sources, and use a variety of modern tools to trade. All these modern traders have something in common: they want to take advantage of technology to boost their income.  

However, the results don’t always match expectations. Even with lower barriers to entry, trading is still hard. Statistically, 80% of traders lose money, 10% break even, and only 10% of traders make money on a regular basis. Looking at these numbers, it doesn’t come as a surprise that 75% of day traders give up in less than two years.

There are many reasons why so many traders fail, and, to the surprise of many, the biggest one doesn’t have anything to do with the unpredictability of financial markets. In fact, it’s psychological in nature.

What is random reinforcement, and how does it lead to bad trading habits?

In trading, random reinforcement happens when you attribute a random event to skill or lack of skill. Beginners are more likely than experts to fall into the trap of random reinforcement and, when they execute their first trades, they often associate unsystematic outcomes to intuition (or lack thereof).

In the long term, the state of the market isn’t random. It’s influenced by economic and political events, and if you learn to analyze them, it won’t seem as volatile. In the short term, however, the market can have small fluctuations that can seem very confusing. At times, these fluctuations can reward bad trading behaviors and punish good ones, leading to overconfidence or loss of confidence.

For example, a beginner trader can win a few trades even though they weren’t backed by a solid strategy, believing that they’re naturally talented, feel overconfident, and continue to execute trades in the same way. In the long term, however, this form of random reinforcement is very dangerous because it resembles gambling, and it will ultimately lead to losses.

It works the other way around, too: a trader who had a plan and did their research can lose trade after trade due to an arbitrary event, believe they have lost their touch, and quit.

Random reinforcement is a major psychological factor that can affect your trading experience, and it shouldn’t be underestimated because it can favor bad habits that are hard to get rid of. In time, random reinforcement can make you think you’re getting better when your trades are actually random or that you’re getting worse when your losses are actually caused by small, normal fluctuations.

In trading, randomness can cause strings of losses or strings of profits. Random reinforcement means that instead of seeing the true reason behind the outcome, you associate the outcome with skill or lack of skill. And that’s dangerous for three reasons:

  • It creates an inaccurate image of your trading skills (both overconfidence and low confidence are major psychological factors that can influence the trading outcome).
  • It makes you create poor trading plans, abandon your trading strategy, and trade based on randomness.
  • It makes you distrust legit sources of information in favor of untested methods.

How to avoid the trap of random reinforcement

Now that we’ve identified the main psychological impediment to successful trading, the big question is: how can you avoid falling into the trap of random reinforcement? Whether you’re a beginner or a veteran, you may be tempted to pay too much attention to randomness, but the best way to fight this instinct is to invest in your education.

A professional trader never stops learning. By researching the principles of fundamental and technical analysis in trading, you will understand all the elements that influence the way the market moves and create strategies that are based on hard facts, not randomness and luck. By having a clear overview of the market, trading becomes a meticulous, analytical activity where you plan your every move and not leave everything to chance. Contrary to common belief, forming a solid knowledge base doesn’t require a lot of time and money. You don’t need to get a degree in finance or enroll in expensive courses because you can always use resources such as The Robust Trader to get answers to all your trading questions and understand how the market works.

Another way to avoid the trap of random reinforcement is to have a well thought-out trading strategy based on your goals and preferred risk level and stick to it. If you want to be a profitable trader, you need knowledge and experience, but these are useless without consistency. While it is totally possible to become a successful trader without prior experience, this process requires time. You don’t become a millionaire overnight, there are no secret shortcuts, and your best bet is to invest in your education and commit to trading. On average, it takes between two to five years to learn how the market truly works and see the results of your efforts, so don’t quit after the first month without letting your strategy play out.

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