Australian (ASX) Stock Market Forum

Illusions of The Stock Market

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When Warren Buffett wrote that investors should have their eyes on the playing field instead of the scoreboard, the emphasis is to focus on what’s hugely important. At the same time, perhaps, his message is more than just how one should use their time, but the peril of constantly checking the scoreboard, the daily stock price. Following the market opens the Pandora’s box of psychological misjudgment, like a nudge to a domino that triggers a chain reaction where biases quickly snowball into insurmountable mistakes.

I’m confident you still remember The Tortoise and The Hare story even though you haven’t read it since childhood. Story simplifies reality so we understand the cause and effect relationship of an event. We seek causal explanation to feel assured. When there’s a significant move in the market, we want to know the reasons that cause the market to fall or how it happened so we can better predict the future. Not knowing the cause create anxiety. But the problem is that most market news stories come with hindsight bias.

Like a word highlighted in a word search puzzle, things always look obvious at hindsight. Any event can be explained from the rearview mirror. The cause of an event can be traced back to its origin with all the indicators that precipitate the event identified and analyzed. At times, we used the most plausible, or nonsensical explanation to explain the past when it’s impossible to identify the exact cause. In Fooled by Randomness, Nassim Taleb points out on the day of Saddam Hussein’s capture, the Bloomberg headline read “U.S Treasuries Rise; Hussein capture may not curb terrorism.” But when the bond prices fell back, the headline reads “U.S Treasuries Fall; Hussein capture boosts allure of risky assets.” We seldom verify and fact checks what’s true (you can’t interview the market). Rather, we go by the coherent of the story to intuitively decide if it is true. This folly of any explanation that fit the bill fool us into thinking the future is as predictable as the past. We fail to acknowledge the future is always uncertain, and the past is a probability of alternative histories: what could have happened instead of what happened.

I am a psychic when it comes to market prediction. My mind can create compelling stories as to why a stock will fall the next day, or how an event will unfold as I imagined. If they didn’t, the news offers plenty of hindsight stories to convince me I knew it all along. I feel good about my predictive ability, not knowing I was fooled by the illusion of causality and finding patterns in randomness as if every ocean ripple can be explained.

Take regression to the mean – a randomness concept where an event with an extreme outcome as a result of luck tends to followed by a moderate one. As an example, if you get head 9 times out of 10 coin flips, which is an extreme outcome, the next 10 flips is going to move closer to the mean – 5 head and tail each. While it’s easy to know coin flip is a game of luck, it is more complicated in business and investing. A business can get a lucky break by riding on an industry boom regardless of the management’s competency. But luck doesn’t make a good story. A riveting story of success needs a deterministic cause as the leading actor: the CEO’s hard work, dedication and past failures that explains the company’s success. But as Malcolm Gladwell wrote in Outlier, “The people who stand before kings may look like they did it all by themselves. But in fact they’re invariably the beneficiary of hidden advantages and extraordinary opportunities and cultural legacies.” Reality is where heredity, environment, luck, opportunity, random chance and hard work intersect to determine our fate. Reality is far more complicated and uncertain than what can be explained by the news in a single, deterministic factor. As a result, we underestimate luck and overestimate our ability to predict under the illusion of control and causality.

I wasn’t a bright student in school but rote learning got me through those years. If I can’t answer an exam question, I’ll pick the most familiar answer. Given that I’ve memorized it before the exam, the answer I’m familiar with should be the correct one. As with everything we do, repetition creates familiarity. What’s familiar often get confused as true. What’s true eventually become part of our belief. The reason why we’re worried about the next market crisis is that we want to avoid capital loss. Fear produces stress and attention. When you’re afraid, you want to keep in touch with the market (The time I spent checking share price quadruple when the market is volatile). It becomes a self-fulfilling prophecy that feeds on itself: news sells the danger of crisis, fear keeps our attention on the market, news reinforce this habit by selling more fear to justify the action of following the market. Through repetitions, we develop a false perception that crisis is the cause of capital loss. What’s familiar get mistaken as true.

Self-fulfilling prophecy, also called confirmation bias, means we have a tendency to reject contradictory information while finding information that conforms with our own beliefs. Remember, we crave certainty and consistency. Holding conflicting information is stressful. As a result, what’s inconsistent with our beliefs gets erased by the mind. In addition, we want to be seen by others as a consistent person. Consistency is associated with trustworthiness. A trustworthy man stands by his own words and does what he says. Changing one’s stance as fast as the wind is perceived as unreliable. Social conformity fuel the need to back up what we believe, even in the face of changing circumstances. When you mix consistency with trustworthiness, you associate your position with your own character. You confuse net-worth with self-worth. We hang on to losers because it’s hard to admit we’re wrong, in particular, when reputation is on the line. We get married to our position.

The incentive of journalism is to make a profit through more readership. It’s easier to sell what’s trivial but sensational – “This stock returned 1000%” or “Is this the next market crisis?”, than the important yet boring – “Good process is the hallmark of good decision”. Survivorship bias is at play here. What’s familiar is what’s sensational – events that make it to the news. We don’t see events that aren’t newsworthy, they did not survive. Therefore, what’s available to the mind are the things that appear in the news. Information asymmetry creates availability bias. As Daniel Kahneman puts it in Thinking, Fast and Slow, “The confidence people have in their belief is not a measure of the quality of evidence but of the coherence of the story the mind has managed to construct.” The ability to construct a coherent story depends on what’s easily available to the mind. In other words, you are likely to overweight low probability, recent events and underweight distant past events due to the asymmetricity of news reporting.

Also called dread risk, we’re afraid to lose money in a market crisis but have no qualms in everyday speculation when the latter has a higher chance of killing you. A cocktail of recency bias and availability bias is a recipe for disaster in the making. Gerd Gigerenzer sums it up in Risk Savvy, “an estimated sixteen hundred American lost their lives on the road due to their decision to avoid the risk of flying [following the September 11 terrorist attack]…This death toll is six times higher than the total number of passengers (256) who died on board the four fatal flights.” Given the attack is all over the news, information availability makes it is easy for the mind to concoct a lucid story which misjudges the probability of getting killed in a plane crash as higher than in a car accident. This also underlies a crucial reality: Probabilistic thinking is hard. But worse when the news magnifies this fallibility. Consider these two statements:

  1. The oil price will hit a record high this year.
  2. The oil price will hit a record high this year due to Iran sanction and higher demand from China.
Which is more probable? The 2nd statement sounds more likely, but it is the 1st that’s more probable. We choose the 2nd statement because it has a coherent story on what causes the oil price to hit a record; we seek causality. A story has a cause, it is vivid and memorable. While statistic is abstract and forgettable.

News does more than distort our perception of risk, it encourages risk-taking behavior. Risk homeostasis is a concept that explains every individual has an acceptable level of risk. If an event is perceived to be safe, you’ll take on more risk. On the other hand, you’ll be cautious with something risky. The notion that one can act swiftly by following the market creates an illusion of safety that increases the appetite for more risk. When you feel safe, you’re relaxed and confident. You trade more frequently. You push the limits. Breaking news incentivize instant gratification. Short-termism and recency bias are the reasons why we pile into a bull run and scramble for the exit door in a bear market. We don’t predict; we extrapolate. Short-termism promotes fear of missing out (FOMO) and loss aversion. You’ll judge your decision based on the outcome of gains and losses. However, the share price in the short-term is distorted by luck. Focusing on the outcome rather than the process only accelerates more bad decisions.

Let’s recap what we’ve gone through so far. The news tends to make an event looks deterministic, certain and knowable by finding the most plausible reason to explain the past, which creates a perception the future is as predictable as the past (Bias: hindsight, causality, certainty, control, predictability). Through repeated experience, we become familiar with these reasonings, and as a consequence, confuse what’s familiar with what’s true (Bias: familiarity, remembering, validity, truth). We have a tendency to find supporting information to confirm what we believe to be true. Social conformity fuel the need to be consistent as well (Bias: confirmation, internalism). Familiarity is also the result of availability (Bias: availability, attentional). Since what’s available is mostly sensational, we misjudge the probability of an event by overestimating recent or events that appear in the news while underestimating things that don’t get reported (Bias: probability neglect, recency). Risk homeostasis theory further means the news increase risk appetite through frequent trading (Bias: safety, knowledge, overconfidence, skill). As if that’s not enough, news incentivize short-termism by promoting behavior driven by market sentiments (Bias: short-termism, outcome). Outcome driven judgment increase the tendency to buy into euphoria and sell in panic (Bias: FOMO, loss aversion, herd mentality).

To be clear, these biases don’t work in a straight line, but in no particular order with one feeding another while simultaneously triggering others. Regardless, the outcome is certain: it is a cocktail of fallibilities that lead to overconfidence in one’s ability to predict. What kills most investors are not market crisis, but their own ego and overconfidence. It is not the level of your forecasting accuracy that gets you into trouble either. Low accuracy is never the problem. Since, if you know what you don’t know, you just have to wait until the odds are in your favor before you swing. Rather, it is when you think you know when you don’t know, when your subjective confidence deviates from the objective truth, that the problem started to snowball.

It seems like I’m suggesting you to pack your bags and move into the caves. Of course not. On a high level, more information does indeed improve decision, but to an extent. As Nate Silver explains in Signal & Noise, “the volume of information is increasing exponentially. But relatively little of this information is useful – the signal-to-noise ratio may be waning.” While we are generating more signal thanks to big data, the noise is growing at an even faster pace. What we need isn’t more information, but better ways to filter the relevant from the irrelevant. How can we have a better filter? Learn how to think well. Cultivate a rigorous, second-level thinking. There’s a misconception that one needs to master complex knowledge before he can become a good thinker. Quite the contrary, good thinking lies in its simplicity – on knowing what not to do. It is about learning how to exercise control over how and what you think and not getting your mind polluted by nonsense so you don’t make silly mistakes. You’ll be surprised by the clarity of your thoughts once you stopped following the market. If possible, learn psychology. Just as the language of finance improves investment knowledge, understand the language of psychology makes you aware of psychological biases that can affect your decisions so you can find ways to avoid them. Most important of all, you want information that helps you to understand the playing field, not those that explains the scoreboard.
 
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Many biases and mental weaknesses can be overcome through a systematized approach which has been back and forward-tested. It's not essential, but it sure helps if you are prone to fear of loss. Even just having a forward test with a Sharpe of 1-1.5 will help enormously. If you don't want to spend time creating this, you can buy a fully disclosed system someone else has created (not a 'black box' system).

Unless you trade fully automated systems (I don't know of anyone), then you are using discretion to some degree or other. Therefore mental factors come into play with almost all traders, whether they acknowledge it or not. I don't think traders need to learn everything about psychology, only learn as much as possible about the topic of fear. Fear is everything. Fear underlies all biases in perception.
 
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Unless you trade fully automated systems (I don't know of anyone)

Don't you read my posts GB? I'm hurt.. (jk) :)

I trade automated systems on the Bund, Kospi, ES and Nikkei Mini. There's not much mention of auto trading on ASF but there's plenty of us out there on more quant related forums.
 
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Don't you read my posts GB? I'm hurt.. (jk) :)

I trade automated systems on the Bund, Kospi, ES and Nikkei Mini. There's not much mention of auto trading on ASF but there's plenty of us out there on more quant related forums.

I'd forgotten about your automated scalping systems capt., sorry! Must be a nice feeling to have a big chunk of the workload taken off you, although I guess it needs constant monitoring in case of internet failure or power outages etc. How do you prepare for that possibility?
 
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I'd forgotten about your automated scalping systems capt., sorry. Must be a nice feeling to have a big chunk of the workload taken off you, although I guess it needs constant monitoring in case of internet failure or power outages etc. How do you prepare for that possibility?

I run the systems on a dedicated VPS with a backup server. All systems are written in Python. I've been using Linux and Ubuntu for over 15 years so wrote most of the monitoring scripts myself. When I'm home I monitor the server directly on my PC and when we're travelling (which seems to be most of the time lately!) I monitor it with a couple of android apps.

It's not something I need to watch constantly, I mainly get alerts if certain parameters are breached etc. I've used a lot of techniques that Howard Bandy has written about in his books in regards to monitoring system health.

I still trade using discretionary methods when I'm home because a lot of picking up new ideas is about observation, something you can't get from an automated system.

We've finished travelling for a while so I'll get back to mechanical systems (not fully automated) on the ASX again too.

Apologies to the OP for the off-topic, happy to continue in another thread if you have more questions
GB.
 

galumay

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What is bias? There is only right or wrong.

Biases are the psychological impulses that affect human behaviour, also known as heuristics. Understanding how they affect the human decision making process can help you make better decisions and also better understand the decisions others make.

Watch the short video I linked earlier in the thread for an insight into how this knowledge can be used in investing.

Charlie Munger's speech, "CHARLIE MUNGER ON THE PSYCHOLOGY OF HUMAN MISJUDGMENT" is freely available online and gives a more detailed insight.

If that whets your appetite, then read Cialdini and also Kahneman.
 
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What is bias? There is only right or wrong.

In terms of trading, I like to define 'un-biased' as the ability to attend to the price action in real time, but totally free of any related memories or expectations. It's almost impossible to do on demand, but anyone who has traded for a while will know the feeling when you get in the zone. If you start feeling like Parker Lewis, then go all in.

Strategy development requires a lot of thinking and figuring. Good discretionary trading requires the stopping of thinking...just feeling, like with sport, art or dance. People get into trouble when they bring a logical mindset to discretionary trading. That's like thinking about how to hit a golf ball - doesn't work.
 
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There are extensive psychology and self eval exercises in books from the likes of Dayton and Elder but perhaps none more practical than as a stop loss held with the broker. Right , wrong who cares, who knows. How much you make when right and how much you dont lose when wrong= priceless
 
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You were biased if you are wrong. You were unbiased if you are right. Why would I care if I'm biased now, I just need to get it right for tomorrow.
 

galumay

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You were biased if you are wrong. You were unbiased if you are right.

*sigh* Imagine getting to this point in the thread and managing to not understand a single word that was posted.
 
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The market is always right. Buffet after all his years experience in business selection has a news paper headline on his wall of a market crash to remind him anything can happen. Dalio attributes a lot of his success to dealing with his not knowing.
No matter how humble or egoless you get or how good you become at F.A or T.A they can only ever give you a probabilistic edge. For beginners like myself there comes a point where you have to pull the trigger and make a trade
 
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In terms of trading, I like to define 'un-biased' as the ability to attend to the price action in real time, but totally free of any related memories or expectations. It's almost impossible to do on demand, but anyone who has traded for a while will know the feeling when you get in the zone. If you start feeling like Parker Lewis, then go all in.

Strategy development requires a lot of thinking and figuring. Good discretionary trading requires the stopping of thinking...just feeling, like with sport, art or dance. People get into trouble when they bring a logical mindset to discretionary trading. That's like thinking about how to hit a golf ball - doesn't work.

GB, I think you just entered the Matrix :)
MY trading has been an amazing journey for me personally. It's very unhelpful for me to think of my trades as right or wrong because I sensed those labels were actually creating their own personal biases.
I'm at the stage now where I think Prechter's theory carries some weight - that an aggregated herd bias is inherent in the markets and that the herd's decision making has derived from neo-cortex decisions.
In this sense, we are all both right and wrong at all times. That is, the market doesnt know how to ascribe objective value, simply because the market is an aggregate of social mood. So we trade on probabilities that we "get" what the herd mentality is trying to do.

It's a very interesting theory because we are all a part of this aggregated social mood - traders, institutions, fund managers etc etc
 
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GB, I think you just entered the Matrix :)
MY trading has been an amazing journey for me personally. It's very unhelpful for me to think of my trades as right or wrong because I sensed those labels were actually creating their own personal biases.
I'm at the stage now where I think Prechter's theory carries some weight - that an aggregated herd bias is inherent in the markets and that the herd's decision making has derived from neo-cortex decisions.
In this sense, we are all both right and wrong at all times. That is, the market doesnt know how to ascribe objective value, simply because the market is an aggregate of social mood. So we trade on probabilities that we "get" what the herd mentality is trying to do.

It's a very interesting theory because we are all a part of this aggregated social mood - traders, institutions, fund managers etc etc

Good one. The mind is designed to do what the herd does - it's a primitive survival thing. So in discretionary trading, if the price rips/dips, you'll feel a pull to go in the same direction. The degree of pull depends on how much you need to be part of the crowd, and that depends upon how free or tied up you are in your own mind. If you are free of your mind (ie. not thinmking too much), then fear will be low and you'll make the right decision. If not, you'll get whipsawed like nobody's business.

Even though it helps to know the herd is usually wrong, sometimes they are very, very right! And as a trader, even knowing all your probabilities, you still don't know if the price is going to revert or not. Maybe it will just keep on moving. Maybe it will keep moving for days on end. All the offline work in the world (drawing levels, lines, contingencies, stops etc) won't save you if you are tied to your mind around the time of placing the trade and when in the trade.

Ideally, you train yourself both in thinking and the stopping of thinking. Thinking should be done offline: to figure out probabilities, perform backtests, understand human nature and potential edges, where to place levels etc. Non-thinking is done online: to get in tune with the flow and feel of the market, place and manage the trade with some degree of regard to your levels/stops etc, but not in too rigid a manner. Skilled, non-thinking dsicretionary trading beats logic and systematized trading any day of the week... it's just that it's much harder to do.
 
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Although I'd happily give up half of any gains if it meant I could fully automate, because the advantages of a passive income are huge.

Start with what you know GB. You've used Amibroker for a while, there's plenty of code available to use Amibroker and IB Controller for auto trading.

I started with Amibroker and used a paper trading account with IB to test some ideas. Initially trading a mean reversion system on the major banks on the ASX before moving to futures. I've had experience with Python and Linux/Unix servers so have gone down that path but there's no reason it can't be done with Amibroker and IB.

The main issue, particularly if you want to scale up, is liquidity. The spread needs to be narrow like it is with the major futures (ES, Bund, Nikkei etc) or you're pushing s**t uphill.
 
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I should also add that if you don't already then you'll probably need to learn a language like Python or another, it's tough to debug stuff if you don't understand programming language structure.
 
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Start with what you know GB. You've used Amibroker for a while, there's plenty of code available to use Amibroker and IB Controller for auto trading.

I started with Amibroker and used a paper trading account with IB to test some ideas. Initially trading a mean reversion system on the major banks on the ASX before moving to futures. I've had experience with Python and Linux/Unix servers so have gone down that path but there's no reason it can't be done with Amibroker and IB.

The main issue, particularly if you want to scale up, is liquidity. The spread needs to be narrow like it is with the major futures (ES, Bund, Nikkei etc) or you're pushing s**t uphill.

Thanks Capt. I have found the ASX just too hard when slippage is factored in. Reversion systems can look superb on a backtest until you are telling the backtester to buy 1-2 price steps below the day's low and sell 1-2 price steps below the day's high. Yet that's what has to happen. The liquidity is never there when you most need it.

With AB and IB Controller, I'd need someone else to help with that and I'm not ready yet. Whilst I have been using AB for ages I'm not naturally inclined to coding and it takes me forever to do stuff. My strength is pattern recognition (visual) and I have occasional moments when I can get my discretionary vibe happening.
 
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