A mental model is an explanation of someone’s thought process about how something works in the real world. It is a representation of the surrounding world, the relationships between its various parts and a person’s intuitive perception about his or her own acts and their consequences. – Wikipedia
- Backtesting uses the scientific method to determine what type of price action trading entries and exits worked in the past to create profitable trading. This is the belief that past data has patterns and useful information to use to identify future trends.
- Availability bias gives too much weight to recent data and experience without looking at the big picture over the long term. The can lead traders and investors to jump for system to system depending on what is currently working.
- Misunderstanding probabilities puts the odds against traders having success by not understanding the chance of success with entries or the risk of ruin due to trading with too much risk. Good traders understand the odds while losing traders are just gamblers with the odds stacked against them.
- Fooled by randomness by looking at small timeframes of price action and small backtests of data a trader can confuse noise with signals. True data has to be verified over a large enough sample size to be meaningful.
- Not understanding the risk of ruin. If one trade can wipe out your trading account or a string of losses then you are trading too big. Your trading has to account for the risk of the worst case scenario and a sequence of losses longer than usual.
- Hindsight bias tricks you into thinking that you could have traded through a time period easily when your edge is only from having access to past data and seeing how it played out. Hindsight is a parasite, focus on what system would have profited from the price data not that you could have navigated it on your own wits.
- Boolean logic reacts off how the pattern plays out. It is just probabilities not predictions. It is a type of algebra where all values are either true or false. Boolean logic is used in computer science as it conforms to the binary numbering system that is the language of computer programming. In a binary numbering system each bit of information has a value of either 1 or 0.
There are both good and bad mental models that can help you in your trading by understanding what mindset creates profitability and the bead mental habits that can cause you to lose money.
Joe Marwood has a free eCourse on Mental Models for the readers of my blog. –> Mental Model Free eCourse