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Alex Barrow spent over a decade working as a US Marine Scout Sniper and as an Intelligence Professional for the government where he specialized in covering the economic and political spheres of the Asian-Pacific region.

Barrow left the public sector to work as a consultant for a ... more

The Fallacy Of Market Prediction

Date: Thursday, January 19, 2017 4:40 AM EST

Spoon boy: Do not try and bend the spoon. That’s impossible. Instead… only try to realize the truth.

Neo: What truth?

Spoon boy: There is no spoon.

Neo: There is no spoon?

Spoon boy: Then you’ll see, that it is not the spoon that bends, it is only yourself.

~ The Matrix

Traders and investors are faced with a seemingly intractable problem when participating in markets — they must place bets on future outcomes which are unknowable even as they’re cognitively wired to be risk averse when faced with uncertainty.  

Put simply: unknowable future + human desire for simple answers = problem.

In this piece we’ll briefly discuss how most people square this peg and also the correct framework you should use instead.

The Brain Is Lazy

The brain is an amazing piece of hardware. It’s comprised of roughly 90 billion nerve cells which are linked together by trillions of synapses. It’s estimated that the human brain operates at approximately 1 exaFLOP. That’s equivalent to a billion billion calculations per second, multiples faster than what the largest supercomputer can accomplish over any meaningful period of time.

But all this processing power takes up a lot of energy — a bit over 20% of the body’s total usage — making it by far the most energy intensive organ.

Because of these large energy needs, the brain has evolved like the rest of the human body for maximum efficiency. After all, the primary driver of evolution is survivability, and energy sources (food) used to be scarce. So the human body evolved to balance a brain that can solve complex tasks — helping us move to the top of the food chain — with a need to efficiently use the body’s energy.

As a result, we got a brain that’s awesome, but also lazy.

It uses a host of cognitive tools (ie, heuristics, biases, anchoring, etc.) as a way jump to conclusions without expending too much energy consciously thinking through every single problem it’s faced with.

For the most part, this system works great. The brain is unmatched in its ability to subconsciously perform pattern recognition and come to an adequate conclusion with little information.

This process is described in Daniel Kahneman’s classic book Thinking Fast and Slow. Kahneman breaks down the cognitive functioning of the brain as follows:

  • System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control.
  • System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.

The automatic operations of System 1 generate surprisingly complex patterns of ideas, but only the slower System 2 can construct thoughts in an orderly series of steps . I also describe circumstances in which System 2 takes over, overruling the freewheeling impulses and associations of System 1. You will be invited to think of the two systems as agents with their individual abilities, limitations, and functions.

Systems 1 and 2 are both active whenever we are awake. System 1 runs automatically and System 2 is normally in a comfortable low-effort mode, in which only a fraction of its capacity is engaged. System 1 continuously generates suggestions for System 2: impressions, intuitions, intentions, and feelings. If endorsed by System 2, impressions and intuitions turn into beliefs, and impulses turn into voluntary actions. When all goes smoothly, which is most of the time, System 2 adopts the suggestions of System 1 with little or no modification. You generally believe your impressions and act on your desires, and that is fine— usually.

When System 1 runs into difficulty, it calls on System 2 to support more detailed and specific processing that may solve the problem of the moment.

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