After finishing off one of the wildest quarters of my trading career, April managed to take the cake. For those that missed it (not sure how you possibly could have), oil settled negative $37. The effects of this were immediate: risk barometers had to be recalculated, option models switched, and most importantly was the immediate […]
Every investor has a mental model of how the world works. Some may call this their philosophy. Other will call this their belief system. These mental models form their rational expectations or rational beliefs. They are rational because they are consistent with the mental model being employed. These beliefs should be unbiased. If they are not, it requires the investor to adjust their model to eliminate the bias.
How do you deal with uncertainty? Some will suggest following rules. Disciplined and systematic investing is the best way to deal with the unknown because there is specific action regardless of the environment. Others argue for flexibility. Unknown or surprise events require special action. When faced with uncertainty, it may be best to adapt and adjust to the specific situation. Arguments can be made for both.
Cognitive priming is a real effect that has often not been discussed with investment decisions and behavioral finance. Suggestions can be used to steer the behavior of investors. Priming is the use of stimulus to create a memory effect or create a temporary increase in accessibility of thoughts and ideas. It is the non-conscious use of memory. It could be used to increase both positive and negative thoughts, ideas, and behavior. Businesses have constantly used priming in advertising to help steer or suggest positive memories. Psychologists have tested priming for years and find that the power of suggestion or linkage is real and extensive. At the extreme, think of Christopher Nolan’s movie Inception on the idea of implanting ideas in memory.
Too often decision-making is bereft of choices. Everything is condensed into a “go or no go” decision, or just an act of rejecting the choice that is placed on the table. This is just a choice between one change and maintaining the status quo. Think how limiting decision-making is under this simple environment. Yes, limiting choices simplifies problem-solving but it also limits opportunities.
Market turbulence just does not happen. There is a catalyst, and the catalyst is a surprise turn of events. Now there are investment surprises everyday, the difference between expectations and realized results. A surprise creating market turbulence is more than just a micro surprise associated with a company but is a signal of a macro regime change.
One of the great problems with forecasting is the fallacy of extrapolation. Forecasters love to believe that tomorrow will be like to today and head in the same direction. Whatever is the trend today will continue tomorrow to the exclusion of other alternatives. There is over-extrapolation.
One of the key problems with decision-making is that it is often simplified into either/or choices. “Yes/no”, “Go/No-Go”, is how we often focus our attention and make decisions. Life is easy when problems are framed as either black or white. For example, the Fed will either tighten or not tighten. Employment will either increase or decrease. The stock market will either rise or fall. These are phrased, in the end, as binary actions. Seldom will you hear a market pundit provide anything other than a binary choice problem. Forecasting is often viewed as being so hard that getting just the direction right may be more than enough to be successful. Unfortunately, framing uncertain forecasts as a binary problem is both near-sighted and flawed.
Gary Klein is one of the great researchers in practical decision-making; however, he has been overshadowed by the behavioral bias revolution and the more popular work of Nobel prize winner Dan Kahneman. That is unfortunate and should be rectified. Klein focuses on naturalistic decision-making; the fact that decision-making in real life is significantly different than anything in a controlled environment.
All investors and traders want to get better as decision-makers. They are open to learning and improvement, and a natural way to gain this improvement is through reviewing their actions after the fact. The old adage is that we will learn from our mistakes. If you have a thorough review process, you can form an effective feedback loop to ensure future decisions will not be driven by the mistakes of the past.
I have an anecdote, but not an antidote, for whatever ails you; that is the problem. Stories or tales of past economic events do not solve investment problems. Investment tales may persuade as a device for action. They may provide useful background information, but they do not provide the basis for an effective solution.
“To derive the most useful information from multiple sources of information, you should always try to make these sources independent of each other. This rule is part of good police procedures. When there are multiple witnesses to an event, they are not allowed to discuss it before giving testimony. The goal is not only to present collusion by hostile witnesses, it is also to prevent unbiased witnesses from influencing each other.” – Daniel Kahneman – from Farsighted Steve Johnson