In the financial market, there are some very famous theories. Some of these theories reveal the truth of the financial market, some analyze human nature flaws, and others point out common cognitive errors.

I often say that trading should be done from a higher perspective, looking down on the market, being the chess player, not the passive pawn.

So today, in this article, I will discuss 7 very important financial theories that can not only broaden everyone's cognition but also help everyone better understand the financial market.

In this way, when you think for yourself and talk with others, you can improve your level of cognition and have a deeper reflection on trading and human nature.

1. Herd Effect

The herd effect is actually about a kind of blind conformity. Normally, the flock of sheep is scattered and disordered. At this time, if a leading sheep moves, the others will blindly follow.

This is very similar to a point mentioned in "The Crowd: A Study of the Popular Mind": when people are in a group, their intelligence is greatly reduced. In order to gain recognition, individuals are willing to abandon right and wrong, and exchange intelligence for that sense of belonging that makes people feel safe.

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In the financial market, people always stir up market sentiment because of some news, or are influenced by the people around them. They enter the market blindly without understanding, follow others to buy and sell, and end up losing a mess.

Or, they like to communicate with others in some groups, watch others show their orders, show profits, and their hearts itch. After being flattered by others, they feel elated, think they are superior, and then they are cut as leeks.

So I say, trading is the same as other industries. To do what others can't do, you need to use your brain, think, and also work hard.In the market, when everyone else is caught up in the frenzy, maintaining a clear self-awareness and judgment of the market, coupled with solid trading skills, is how we might achieve true stable profits.

Why can't trading strategies be generalized?

From a technical standpoint, different trading systems have different criteria for judging market trends, and they have different entry and exit points. Just because someone shows a few profitable trades does not mean their trading consistently yields profits.

Moreover, the profitability of a trading system is cyclical. Often after a period of consecutive profits, a decline is bound to follow. However, most people only share the good news and not the bad. If you blindly follow these trades, the likelihood of losses is very high.

From the perspective of the trader, trading is a very personalized activity. Each person's risk preference, personality traits, and trading habits are different.

A trading system must be tailored to one's own personality. For example, the frequency of trading, the time horizon for holding positions, the size of the position, the size of the stop loss, whether to prioritize high success rate or high profit-to-loss ratio, etc., all need to be adjusted after a period of trial and testing.

Someone else's trading system may suit their personality, but it may not suit you or me. Blindly following can only lead to a loss.

This is why I always advocate that I won't give you trading signals, but I will teach you how to trade, how to adapt to your own trading strategy, in order to achieve a trading system that fits you.

2. The Butterfly Effect

The Butterfly Effect originally referred to a meteorological phenomenon. In 1963, an American meteorologist proposed a theory that a butterfly occasionally flapping its wings in the South American tropical rainforest could trigger a tornado in the United States two weeks later.The butterfly effect was later introduced into various fields of economics and society, broadly referring to small events or unintentional incidents that trigger a series of significant reactions, even a black swan event.

A representative event of the butterfly effect in the financial market is the 2008 global financial crisis. This financial crisis began with the default of subprime mortgages in the United States in 2006 and started to sweep across the main financial markets of the United States, Europe, and Japan in August 2007. The subprime mortgage crisis also became the catalyst for the 2008 financial crisis.

In fact, the butterfly effect is also vividly reflected in trading:

A friend once approached me to discuss his experience, which I remember very vividly. He said he was already in debt of more than two million, and I asked him if his positions were too heavy, to which he replied no.

He said that at the beginning of trading, each position was only a few hundred dollars. When he encountered a fast market, he would use a very small position to catch a rebound, and sometimes after a few rounds, he could make a few hundred dollars.

However, as he encountered such situations more often, he couldn't help but increase his positions. His greed was uncontrollable, and as a result, when one trade got stuck, he immediately added to his position below. Then, when he encountered a one-sided market, his positions became heavier and heavier, until his floating losses were significant, even leading to a margin call.

He said that after the margin call, his first thought was where to get some money to try again. He was unwilling to accept that his money was gone just like that and also felt that it was just bad luck.

As a result, he kept trying and failing, his debts kept growing, he sold his house, his wife divorced him, and his child was taken away.

As he spoke, he burst into tears, repeatedly saying one sentence: This was clearly just a trade of a few hundred dollars, how did it turn out like this?

In fact, when I was early in my trading career and did not have a trading system, I also experienced all of this. So, apart from helplessly sighing, there was no other way.Now my own ironclad rule is:

"Do not act on small positions," if it does not conform to the trading system, and there is no trading plan, I will not make orders even for small positions. Making money with these small positions is like picking at a fly's leg; if not handled properly, it can lead to a significant loss. Besides satisfying our trading addiction, it has no meaning.

3. The Barrel Theory

Everyone should be quite familiar with the barrel theory. The amount of water a barrel can hold is not determined by the longest stave but by the shortest one.

Some people often tell me that their trading system has a win rate of over 80%, or a profit-to-loss ratio of 5:1, even 10:1, and they ask me how I evaluate their trading system.

I can only say that such a trading system theoretically has a very obvious advantage, but it is absolutely impossible to make a profit in actual execution.

This is because a very high win rate is accompanied by a very low profit-to-loss ratio, and a very high profit-to-loss ratio is accompanied by a very low win rate. You either go through a long period of consecutive losses or experience very low profits per trade. From a human nature perspective, such a system cannot pass the test.

A trading system emphasizes balance and should not have any obvious weaknesses, otherwise, it is difficult to achieve profitability.

The four basic elements of a trading system are direction confirmation, entry, exit, and money management, which form a whole. These four elements must work together and be balanced and reasonable. If there is a weakness in any aspect, profitability cannot be achieved.

My personal view is to prefer the path of moderation and not to pursue extreme profits.For instance, my own trading system has a reward-to-risk ratio of 2:1 and a win rate of around 40%. This is the most comfortable and balanced position I've found over the years, allowing me to achieve an annual return of about 40% without too much discomfort.

Of course, from the beginning to the end, I encourage everyone to test their own limits: how many consecutive losses can you withstand, what level of annual profit can satisfy your desires, what trading frequency can stop the itch to trade, how many trading instruments can you manage, and so on.

These are all experiences and tests that one must go through to make the overall trading system balanced and in harmony with oneself, in order to achieve profitability.

4. The Watch Law

The Watch Law is easy to understand. When you only have one watch, the time on that watch is your standard, and you can clearly know what time it is. However, once you own multiple watches with time discrepancies, you may feel confused and not know what time it is.

In trading, people often wear "multiple watches" as well.

Many people like to add complexity to their trading strategies, such as incorporating various indicators or executing multiple trading systems at the same time. They believe that the more complex their trading strategy is, the more incomprehensible it is to others, the more sophisticated it appears, and the more impressive they are.

In fact, in the early years of trading, I also fell into many similar pitfalls. I studied dozens of indicators, hundreds of trading strategies, and read countless books. But when you absorb so much knowledge and apply it to actual combat, you find that trading is a matter of simplifying complexity.

We should subtract from our strategies, not add to them. Some friends leave comments under my content, saying that they have achieved long-term profits with an extremely simple strategy, and they can't believe it. They ask me if it's real and reliable.

I'll give an example to illustrate. In a rapidly fluctuating market, if your entry criteria are simple, you can quickly determine whether this market meets your entry criteria. If your entry strategy is complex or ambiguous, you are very likely to miss the opportunity to enter.In the book "The Clarity of Wisdom," there is a statement: Traders should "legislate for trading." Traders should establish their own criteria for judging direction and formulate an execution plan for trading according to their own judgments.

We need to clarify our trading goals. The sole purpose of our trading is to make money, not to be perceived as "impressive" by others. If a strategy is complex and only wins face without having real profitability, then it has no need to exist.

Let me provide a standard: a conventional trading system uses about 3 to 5 indicators, and a simple trading system only needs 2 to 3 indicators. Too many indicators can cause confusion, increase the difficulty of execution, leave us at a loss, and affect trading profits.

Additionally, do not be greedy with your trading systems; do not think that you want to engage in every market situation. Your capital is limited, and your risk tolerance has its maximum value. Multiple trading systems will only disperse your focus, making you very tired, and ultimately, the money you earn will not be much different from that of a single trading system. Multiple systems may even lead to more mistakes in the hustle, which is not worth it at all.

If you want to keep yourself busy, you can increase your trading frequency by adding more varieties, or you can develop habits of reading and exercising, which also benefits your independent thinking.

5. The 80/20 Rule

The 80/20 Rule originated from the Italian economist Pareto, who in 1906 proposed a conclusion about the distribution of social wealth: 20% of the population controls 80% of the social wealth, hence the 80/20 Rule.

Later, the 80/20 Rule was introduced into various fields, such as business, science and technology, humanities, and so on. For example, in management science, 80% of a company's profits come from its 20% of projects. It is said that 20% of people bring tomorrow's tasks to today, while 80% of people postpone today's tasks to tomorrow. The 80/20 Rule has many interesting examples in life.

The 80/20 Rule also has a similar effect to the theory of extreme Stan in "The Black Swan." The distribution of resources in this society is unfair. How to snatch meat from the hands of a few people requires a certain amount of courage.

Some friends enter the financial market for rather hasty reasons, simply thinking that the financial market is easy to make money.Whenever I hear this kind of talk, I just want to knock on their heads. I completely understand many of my male compatriots who are not satisfied with their real lives and want to achieve a leap in wealth through other means, but trading is really difficult.

What you have to face is a test of your learning ability, a test of your human nature, a test of your patience and attention to detail, and so on.

Everyone says that trading has a low barrier to entry, and you can start with just a little capital, but to make a profit, the threshold is very, very high.

So I suggest that everyone should think clearly about these things before trading:

First: Do you have a clear understanding of the risks of trading? If all the money you invested is lost, can you bear it?

Second, can you immerse yourself in learning? If you just trade recklessly, what you are doing is gambling, not trading. Learning trading techniques and fundamentals requires mastering a lot of knowledge, and it takes the ability and courage to immerse yourself in learning.

Third, what if you can't make a profit from trading? Can you withdraw completely? How much spare money can you use? Can you stop the loss in time?

Ask yourself these questions, and if you can do all of them, then we can enter the trading.

6. Alligator Principle

The Alligator Principle refers to the situation where if a crocodile bites one of your feet, you should never struggle, nor should you try to free the bitten foot with your hand, otherwise you will be dragged into the water by the crocodile, and the only way is to sacrifice the bitten foot.The principle shares a subtle similarity with the concept of stop-loss in trading.

Many people despise the stop-loss in trading, viewing it as a sign of failure, a loss, and a loss of their own money. However, for those of us who have been through many battles in the trading field, stop-loss is a common occurrence, and it doesn't even cause a ripple in our hearts.

I once wrote an article discussing the issue of risk. In the early days of commodity trading, it was a barter system. In the financial markets, trading is about exchanging risk for profit. Without risk, there can be no profit.

Take my trading system as an example: a 40% win rate, a 2:1 reward-to-risk ratio. In 100 trades, I make a profit 40 times and stop out 60 times, with each profit being 200 yuan and each stop-loss being 100 yuan. After 100 trades, the final result is definitely a profit.

When encountering 60 stop-losses, do I not feel heartache and discomfort? Of course, I do. But you are very clear that you cannot expect a trading strategy to make money all the time, on every single trade; that's something that only exists in dreams.

So, to avoid the pain of continuous losses, I choose to maintain a certain distance from the market, ensuring that the trading system is executed normally without constantly monitoring the market.

As time goes on, I get used to the existence of stop-losses. As long as you don't focus on each trade in the moment, but instead look at the long-term profit results, you will have less feeling about the outcome of each trade.

Over time, you will also accept the existence of stop-losses. This is my experience.

How to implement stop-losses?

Stop-loss is an element of a trading system, and it is meaningless to discuss stop-losses without considering other elements. I have also written more comprehensive articles on trend judgment, entry, exit, and money management before, which you can look up in my previous writings.The method of setting stop losses must be coordinated with other elements of the trading system, and the optimal stop-loss plan should be determined through backtesting, rather than arbitrarily setting stop losses.

7. Anchoring Effect

The anchoring effect refers to the influence of first impressions or initial information when we make judgments about a person or an event. This preconceived impression may lead to a distortion of the facts.

Many people must have experienced this:

At the beginning of trading, they were naive and didn't understand anything, so they invested some funds casually and found that they were making profits all the time; or they started with a simulated account, set a large amount of funds, and no matter what they did, they were profitable.

From this, they draw a conclusion: trading is really simple, I might be a trading genius, and I am very suitable for trading.

Then they change their original goal of "as long as trading can make money, it's good" to making a profit of 50%, 80%, doubling, or even several times, and they can no longer look down on some small profits.

In my early days of trading, I encountered many highlights, making thousands of US dollars in a day, and at that time, I felt great, already looking at the models of Ferrari.

Looking back later, I realized that doubling my trading profits was just due to my good luck, with heavy positions and market conditions that matched, which set me an incorrect "anchor," leading to later heavy betting on the market, not setting stop losses, and against-the-trend replenishment, resulting in long-term stable huge losses.

In fact, the most terrifying thing is not that you are losing all the time, but that it is difficult for you to redefine a correct "anchor" again, because a blank sheet of paper is easy to define, but a distorted anchor is not easy to correct, which also cost me the greatest effort in my life.So, I always say, when it comes to trading, observe more, learn more, and do less. Before you have the right understanding, you need to incur some trial and error costs. These costs can be actual money, or they can be achieved through extensive learning.

If you have already entered the live market, it is imperative to keep a trading journal, conduct periodic reviews and reflections, and examine why you are profitable or why you are losing. You should also assess whether your trading strategy is problematic, whether it needs adjustment, and whether timely stop-loss measures are necessary.

Additionally, before going live, you must rigorously test your trading strategies to determine if they have the potential for long-term profitability. If you haven't tested them, do not begin.

In the financial markets, human nature is the most difficult to defy, which is why I advocate for standardization, clarification, datafication, and probabilification. The aim is to help everyone avoid the shortcomings in their own nature and to avoid defining the wrong "anchor." I hope everyone can understand my good intentions.

The above seven effects are the most critical in the financial markets and are also the seven financial principles most closely related to our practical trading. By leveraging these principles and observing the market from a higher perspective, you can gain a new understanding and cognition of trading, which I believe will be helpful to everyone.