Friday, March 24, 2006
ELIMINATING BELIEFS AND BIASES
Part of knowing how to extract money from the market is understanding the irrationality that oftentimes exists within the market. In Michael Lewis’ book Moneyball, John Henry (hedge fund manager and owner of the Boston Red Sox) is noted as saying, “People in both fields (baseball and trading) operate with beliefs and biases. To the extent you can eliminate both and replace them with data, you gain a clear advantage” (p. 90-91). This clear advantage is what we call ‘edge.’ Many times edge appears in the form of information while in other cases edge can simply be the realization that humans are prone to make irrational decisions when faced with uncertainty. These irrational decisions oftentimes appear in the contexts of social interaction, sampling bias, and anchoring.
People are social by interacting with one another. Market pricing is created by people; therefore, pricing is influenced by social interaction. Most commonly we see this in the market through herding behavior; however, on an individual level, social interaction can have a dramatic influence on your opinion or level of conviction in a trade. Ever have a strong opinion on a trade, then someone with more experience or whose opinion you respect or who is on a ‘hot’ streak is not as bullish as you are on the position so you start to change your mind or question your conviction?
How to Solve: If you have the discipline to step back and eliminate the outside beliefs, then you can clearly evaluate what remains.
I agree, numbers do not lie…but they can be deceiving. When faced with uncertainty, people tend to look for easily accessible information as a basis to form their opinion. The most easily accessible information is either in their memory or right in front of them at that time. As we all have experienced, people tend to have selective memories - meaning remarkable events tend to stick in our memories and we use it as a foundation for forming opinions. For example: which is more likely to kill a person in the United States: a) a shark attack or b) a falling airplane part? Answer: airplane part is 30 times more likely. As far as information in front of us, if I wanted to find out who baseball fans like more, the Yankees or Red Sox the answer would probably be different if I asked people who live in NY (which is easily accessible for me) compared to driving to Boston (which is not easily accessible for me).
How to Solve: Be aware of where your sample is coming from and take that into account when forming your opinion so you do not make the mistake of believing that the findings from a small sample are always representative of a larger sample.
Anchoring occurs when a person is faced with an uncertain situation that they need to quantify.
During this uncertain period of time, people are easily influenced by outside (and sometimes irrelevant) data points which create a psychological “anchor” for them to base their future opinion. Traders experience this by anchoring to a stock price and then forming their opinion about how high or low that stock can go in the future, relative to that previous price. The flaw in this price quantification is that the past price was determined by past events while the future price will be determined by future (and oftentimes) unknown events. Ever heard the cliché previous performance is not an indication of future results?
How to Solve: Focus on remaining objective and embrace the notion that the market reflects perception before it reflects reality. Make decisions based on the idea that your goal is to make money instead of being right.
All in all, understanding when human opinion becomes irrational can create a lucrative window of opportunity for those who are paying attention.
Keep your eye on the ball and your head in the game!
Copyright 2006, Doug Hirschhorn, Ph.D. All Rights Reserved