Emotional Decision Making and Loyalty
to Preconceived Notions
It is always the same behaviors that seem to make us
happy but destroy us at the same time and no more is
this true than in the financial markets. People may
change but the way we make decisions remains the same.
When we say someone is a new person we are referring to
the person’s social status, outward habits, and their
portrayal to the outside world, as we can never be
certain how they see themselves. They may be a new
person but the process that we use to analyze them is
always the same. The process that they used to get to
their current state is also always the same. Seems
Strange? It shouldn’t for the process’s that we use in
everyday life as in investing is always the same.
As John Maynard Keynes said
investors must anticipate "what average opinion
expects the average opinion to be".
In financial markets loyalty to one’s belief have
caused the downfall of many traders that had in the past
accumulated vast personal fortunes. Since markets are an
evolving and changing, ideas that may have worked in the
past will suddenly stop producing profits and our
failure to let go of those ideas will cause us to
eventually give back to other participants the gains we
accumulated over the years. This is akin to day traders
making a killing in market X but as more participants
enter this market armed with the same information then
expected returns start to diminish until they are
actually negative net of transaction fees.
Successful investing meets disaster
when the environment changes.
The best way to illustrate a concept is with an idea
that is well known and generally accepted as a truth. In
fact it is accepted as such a truth that many have made
careers even businesses selling the concept but few are
successful practitioners. The markets are a visual thing
when converted to charts and the human mind is patterned
to see trends in data whether they exist or not. Why
would we want to see trends? Trends are the easiest
pattern forms to recognize and transmit for people. We
often refer to fashion trends, business trends, music
trends, artistic trends, technology trends etc. and all
these are valid except these are qualifyable matters but
more importantly by the time they are recognized as such
most of the profits have already been made by the
developers of these trends. In business trends are made,
in the markets trends are the after affects of people
acting as a group. This is the traceable evidence of
what is commonly known as herding.
Trends in the markets are commonly shown in charts as
the equity price crossing over a moving average
(typically 20 or 50 days) or as one moving average
crossing over (or under) another moving average. The
simplicity of the idea makes it beautiful. Being simple
it is easy to understand and communicate to others. This
conceals the ugly of whether it is profitable. Most
people do not bother to test trends on a simple trading
system for two main reasons:
- It requires effort
- Their belief it is profitable
Expending a little energy now may save us from future
disappointment. However, when we have made a decision
after a stock moved over its moving average the only
thought in our mind is how big our profit will be. To
bad we do not spend more time exploring the idea of
possible losses before we place our money on a security
to outperform the one we just sold, we spend more time
on planning a trip comparing airline costs, hotel costs,
destination choices, and where to book our trip.
There is a strong desire by
the investing public and institutions to make
large gains in the short term rather than aim at
the long run for profits.
If you have already decided that trends exist and are
profitable than we will have great difficulty or maybe
even improbable that you may be able to see trends
otherwise, your loyalty is first to preconceived ideas.
Trends may hold a moderate level of success and the
home run hits that are sometimes achieved are the real
motives that keep us believing. The feeling of perceived
control that we feel have over our financial future is
psychologically healthy. The feeling of trends can be an
extremely positive experience. The following is the
order that we believe trends can instill in the
believer:
Positive Feelings
Positive Expectations
Positive Feedback
Positive Trend
The above four items appear to one degree or another
in the random completion of trends. There is even a name
for failed trends, whiplash. Why would trends fail so
often? A good explanation could be found in Prospect
Theory – people have less of a tendency to gamble with
profits than losses. Thus trends for the most part are
unable to normally develop. There seems to be more of
take your profits and run than cut your losses and let
your profits run. The old belief that
the trend is your friend
seems for the most part to be part of a rational world
and not the actual world of traders. One area that
prospect theory may support the trend theory is for
trends heading down (selling short opportunities). Since
people will not act quickly on losses there may be more
of chance for trends to develop. We may explore this
phenomenon in the future.
Key Ideas
Trends
Inflection points
Already weak
Gives sense of confidence
Better than no strategy
Evaluation Heuristics
Conjunctive fallacy
Availability and Scarcity
Anchoring and Insufficient Adjustment
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