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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

Since most of you aren’t Jim Simon, this exception probably doesn’t apply to you. Most of us are left using our minds in the best way possible to arrive at better outcomes.

How You Should Think About Markets

“As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” ~ Donald Rumsfeld (emphasis mine)

Markets are full of unknown unknowns.

No matter how smart you are, or the amount of advanced tools you have at your disposal, or even how much exhaustive research you do, you’ll still be partially blind when putting on a trade.

And the dangerous thing is… you can never know exactly how blind you are.

We need to implement a better mental model for markets when dealing with these unknowns.

Possibilities not probabilities.

Probabilities imply linear and rigid known and unknown outcomes. They instill false confidence.

Possibilities imply the dynamic, fluid acceptance of unknown unknowns. They confer insecurity.

Thinking in possibilities instead of probabilities not only makes you a better risk manager by stripping you of your overconfidence, but it also primes your brain to avoid fixating on a single set of outcomes.

Fixating on a single set of outcomes wires us to look for confirming evidence while blinding us to opposing information. This is called confirmation bias. This bias tends to become more powerful the more time you sink into researching an idea (sunk cost bias).

Thinking in possibilities keeps our minds open to competing and opposing information. This is absolutely vital for any trader or investor who wants to have long-term success in markets.

It’s the whole “strong convictions, weakly held” idea. In fact, it’s an integral part of being mentally flexible, which is one of five key character traits of all the greatest traders.

It also keeps our conviction in check.

When filled with a strong sense of humility, knowing we don’t know all the key variables, we tend to operate in a manner more conducive to better outcomes. We manage risk better, size positions better, and are more apt to recognize when we’re wrong, allowing us to quickly become right. As Ray Dalio would say:

You can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.

Here is a sketch of a better way to think about markets.


A Better Way To Think About Markets


A crucial part of thinking in possibilities is defining what inputs (price action, fundamental news, sentiment, etc.) would raise or lower your conviction for each possibility.

Basically, define what’ll convince you that you’re wrong and also what’ll increase your conviction that you’re right.

This is not a one-time process. It’s a continual study that you should be running in the back of your mind. Since the market is fluid and always changing, so should be your conviction levels on what’s possible and likely.

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