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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

We’re not going to go into more detail here on the benefits and disadvantages of the System 1 and System 2 model, nor the host of tricks the mind uses to make this system function (here’s a cool Bias Codex). Those have been covered elsewhere and if you play in the markets, then you should just read the book. It’s worth your time (side note: Michael Lewis’ new book is a good primer on Kahneman).

All you need to know is that the brain evolved to seek out simple, linear answers when confronted with complex situations, especially where there’s an information deficit.

Basically, the brain is not well suited for markets.

Squaring the Peg: How Most People View Markets

For the many advantages that our brains offer, they can be extremely dangerous to our trading capital.

That’s due to the following two reasons:

  1. Our brains operate on pattern recognition and therefore like simple, linear answers.
  2. Information overload results in cognitive tunneling (System 1 thinking) and our minds instinctively follow the path of least resistance when confronted with complexity.

The problem with “reason 1” is that markets are not simple or linear. They are endlessly complex and dynamic.

Therefore “reason 2”, following the path of least resistance in coming to conclusions, is the opposite of what you should be doing.

These cognitive handicaps lead people to think that prediction in markets is possible. It’s not.

The prediction fallacy is based on the assumption that the future is fixed (linear) and all important variables are known (total information). This is, of course, patently false.

Regardless, many of us still subconsciously use this mode of thinking as our primary mental model.

Here’s a sketch of how most people think about markets.

 

How Most People Think About Markets

 

Simple and linear.

Here is how slightly more “sophisticated” market participants think about markets.

 

How Slightly More Sophisticated Market Participants Think

 

This is better than Figure 1, but still wrong.

To think in probabilities is to give a statistical weight to different outcomes. But this statistical weight is useless — sometimes worse than useless — because a number of essential variables will always be unknown. On top of that, you can never know just how many of these unknown variables there are. Therefore the situation is not actually calculable, nor repeatable.

Thinking in probabilities leads to false confidence and suboptimal outcomes.

The market isn’t like Poker where assigning probabilities using known variables and experience makes sense.

In poker, things are quantifiable. You know how many cards are in the deck and you can calculate probabilities for your hand and the other hands at the table. You can then use these in conjunction with bet amounts to arrive at a statistically meaningful edge where you can surmise both pot odds and the expected value of your actions.

Of course, like in all things, there are some exceptions. Quant and algorithmic traders, for example, exploit inefficiencies, quantitative correlations, and other relationships to find statistically meaningful edges. But these are often very short-term and eventually always get competed out of the market. This is why quant funds need to continually evolve to find new edges.

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