Irrational Beings

No doubt you'll be aware of the pullback experienced by global markets over the past couple of days. To quote Chris Tate from the Trading Game Mentor Forum today:
"Market go up - market go down. I try not to distract myself with prognosticating as to the reasons 'why' something happens. No doubt tonight's news will be full of people offering reasons as to why it happened and the occasional genius saying 'I told you so'. In the end these are just attempts to find reason within a system we cannot understand."

Tate on Trading - Irrational Beings

Within the world of trading one would have an expectation that rationality was a key underlying feature in not only the decisions we made, but also the underlying philosophy that guided market participants in general. Unfortunately that expectation is wrong and not a little bit wrong – it is wrong on a galactic scale.
Now I know some of you think I am going to give the crystal hugging, Gann line drawing, "I can predict the future" astrology nutbags another belting. Well, you'd be wrong and whilst that is fun, more amusing is the hate mail you get. And what's more fun than that is the second deluge of hate mail you get after you have written back to tell them their stars should have warned them that someone was going to slag them off. It's at this point you understand why such people should not be allowed to run with scissors and are reduced to the embarrassment of having their mother write their name on their undies and sew five cents into the corner of their handkerchief.

However, I digress, the lack of rationality I want to examine pertains to what I feel are certain interconnected myths within the market that often hold sway over a trader’s subconscious without them realizing it.

Market Myth One

"I am due for a winner".

This falls into what I call football statistics – everyone has heard a football coach or commentator state that such and such team is due for a win. For a start who says so – wins and losses are not divided up pre season and the handed out when some divine force takes pity on a team.

Traders fall for exactly the same mentality and believe that after a series of losses that they are due for a win as if the market will take pity on them and throw them a bone. Consider a study done with 40 PhD’s who in a simulation were given $10,000 to trade. The rules of the game were simple when you won your return was equal to your initial stake. So if I bet $1,000 and won I got my stake back plus $1,000. The odds of being successful in the simulation were 60%.

Of the 40 involved only two made money – the rest went bust. The prime reason for their failure was their inability to understand probability and its role in trading decisions. For example after three consecutive losses of $1,000 the majority of traders tripled the size of their next bet in the belief that they were due for a win despite the fact that the odds of the game had not changed.

Traders fall into what I call the Tattslotto fantasy – this fantasy says that traders/investors/gamblers will overweight the likelihood of a favourable outcome. Yet if you read the profiles of successful traders you find that they tend to do the opposite – the overweight the negative and are constantly on the lookout for the market proving them wrong.

You don't have to be a master statistician to trade but you do have to understand that the rules of the game don't change just because you are playing it.

Market Myth Two

"I am special".

Only in the eyes of your parents is this true – to the market you are just another player who will get carried along to wherever the market is going. My name for this malady is "the myth of individual specialness" or "I am little sunbeam".

Interestingly this has a lot in common with the first myth. I find this myth to be particularly prevalent in people who are attracted to intra day trading within FX markets. All the available data says that the majority of daytraders lose money – they then go nuts and shoot everyone around them, but that's a side issue.

Despite being told this and being shown quantitative evidence that their chances are slim, people still insist on trying it and the reason they don’t believe the statistics is because they believe they are special and the laws of probability don’t apply to them. Consider an analogy. If I told you that the next time you crossed the road without using a pedestrian crossing that there was an 80% of you being killed, I am fairly certain you would go out of your way to find a controlled crossing. Yet in trading this sort of logic flies right out the window.

As a side issue, people who lack critical thinking or who engage in magical thinking will tend to cling more strongly to their beliefs after being shown evidence to the contrary.

Market Myth Three

"I must never lose money".

Trading is a profession where losing money in inevitable – it is inevitable that you will have losing trades. However, this is not a catastrophe since there is no relationship between the number of times you are correct and the amount of money you make. You see, the market doesn’t reward your ego. It doesn’t care how many trades you get right. What it cares about is how much you lose on the ones you get wrong because this is the determinant of your success.

The ability to take losses reveals in the individual a knowledge that trading is simply a numbers game and that each individual is at the mercy of these numbers. This is not a bad thing since it enables you to surrender control for the need for prediction. This is why I believe that prediction is a fool's errand. Not only is it impossible but it sets the trader up for continual disappointment followed by an often slow agonising death as a trader.
- Chris Tate

 

I think a number of people on here need to read this quote very very closely. Once again an excellent post from Tropo.

Mark

 

Yep, I agree with Tropos post. Its not mensa really...

That's why I just sold out my entire $600K holdings based on my observance of the channel the ASX was trading in. I didn't try and justify the decision based on some deep understanding of the macro-economic environment, all I did was recognise that it was at the top of the range and had traded up quite sharply for a while and might be due a correction. Those corrections, or pull backs or whatever you call them are all just due to investor sentiment and the fact that all of the world's equities markets are "imperfect". You can never precisely price a stock so there is always some sentiment built into the price. If investors get scared prices come off, if investors get bullish and bold they rise. You're better off watching the herd if you're looking for the best indicator of where prices are headed in the short term.

For me now its still going to soften a bit. Why? Because everyone is still scared about this correction and how much is left to play out. If all I ever heard about was how ridiculous this pull back was and how many awesome bargains there are now then I'd be crystal balling a rise.

So my money's on the sidelines for a little while yet. Might take a few weeks to shake the jitters out and get some confidence back. Then its onwards to 7000 but no gaurantees its a straight line (or that we'll even get there by the end of 2008 as some are suggesting).

All great fun isn't it!

Cheers,
Michael.

 

Spoken like true technical analysts!