Chapter two of my book Trade Your Way to Financial Freedom is about judgmental heuristics. Basically, we have a limited capacity for processing information. In fact, consciously we can hold 7 (+ or - 2) chunks of information. And that dramatically reduces under stress when the blood flow is diverted from the brain to the major muscles of the body to deal with approaching danger. But in today’s world, the danger is usually mental and being able to run faster doesn’t help us deal with any trading dangers.

Every year the total amount of information we have to deal with as traders doubles but our capacity stays the same. As a result, we’ve developed a number of shortcuts (i.e., heuristics) to processing information. In fact, psychologists have been documenting many of them over the years and have been calling them judgmental heuristics.

The overall conclusion is that we as human beings are very inefficient at processing information. In fact, some economists have begun to move away from the “efficient market” camp into the idea that “markets are inefficient” and the reason that they are inefficient is because humans are inefficient decision makers.

This conclusion is excellent, but what they’ve done with it is not excellent. What’s happened is that a new school of economics has sprung up, called behavioral finance. And what the economists are trying to accomplish is to say, “Well, if markets are not efficient because humans are inefficient, then how can we use what we now know about human inefficiencies to predict what the markets will do.” In my opinion, this is lunacy.

In fact, you might call what I do “applied behavioral finance.” But I take a different approach. I say that if most human beings are inefficient in how they process information, what would happen if you start to make them efficient? Let’s say, a human being is 5% efficient in dealing with market information (and this is probably a high estimate for most people). What would happen if I could make that person 25% efficient? What would happen if I could make that person 50% efficient? Or what would happen if I could make that person 100% efficient?

Well, the results might surprise you. In previous tips, I’ve talked about how trading systems might be consider to be a distribution of R-multiples with a mean (i.e., expectancy) and standard deviation that characterizes the distribution. And if you don’t understand that, go back and read some of my earliest tips or, better yet, go buy Trade Your Way to Financial Freedom.

Let's say you have a system that gives you an expectancy of 0.8R and it generates 100 trades each year. And, as I've said before in prior tips, such a system is not unrealistic. I've seen much better systems. That system, on the average, will generate a return for you of 80R per year.

And if you were to risk 1% per trade, you could probably make 100% per year trading it (i.e., 1% gets bigger as your equity grows which is why you could make 100% and not 80%).

However, because of behavioral inefficiencies, such as those discussed in chapter two of my book, most people will make lots of mistakes. And what's a mistake worth? I don't know for sure, because we need to collect a lot of data to figure that out and it'll be different for everyone. However, for now, let's say a mistake is worth on the average 4R.

If that's the case and you make one mistake each week, then you'd have 208R worth of mistakes, and you'd lose money trading that system that could potentially give you 100%. But let's say that you only make a mistake per month and most profitable traders probably do that. How about you? If you make a mistake a month, that's 48R lost out of 80R, leaving you 32R in profits. During a severe drawdown in the system, you might totally give up on the system, not thinking it was a good system.

And now let's look at the trader who makes one mistake a month. Our system generates about 7-8 trades per month, so we could say that he one makes one mistake per 8 trades in executing his system or he's 87.5% efficient. But in terms of profits, he's only made 32R out of a potential 80R, so it looks like he's only 40% efficient.

So what would happen if he could become 60% efficient, or 80%, or more? The return increase would be phenomenal. So perhaps it's time to read about some of the common inefficiencies that we as human being have and learn how to become more efficient as a trader.

Until next week, when we'll discuss "Trading Objectives," this is Van Tharp.

Until next week, this is Van Tharp. Have a good weekend.