- Predictions do not work as tomorrow is uncertain. We will only boast about things we have predicted right and talk nothing about the other half we got wrong.
- Skills can bring us moderate success. However, luck is needed to be a big success. (credit to Jon)
- We tend to credit our successes to good skills and blame our failures on poor luck.
- Some of us rely on luck (most unknowingly) by investing for high returns (and losses). A few of us will make big money but most of us will end up much poorer.
- Some of us deliberately limit the luck factor by choosing investment products with capital guarantee and guaranteed returns. None of us will make big money but none of us will be very much poorer.
- We need to know how much we can afford to lose (financially and emotionally) before deciding to be No. 4 or No. 5, or somewhere in between.
- We have many biases. The degree of success in investing or trading depends on how much we can keep our biases in check. No, we cannot remove our biases totally.
- Confirmation bias – we see what we want to see. We seek out evidence to validate our investment decision and ignore those that suggest otherwise.
- Availability bias – we are influenced by the things we observe. If people we knew made a lot of money through property investment, we will think that properties are the best investments in the world and develop a preference for it.
- Loss aversion bias – we want to be compensated for high returns before we decide to take the risk to invest. We often wait for markets move and show high returns before we want to invest. We are not interested if markets are not moving.
- Hindsight bias – we tend to say “I knew it” after an event has happened.
- Survivor-ship bias – we only get to hear stories of successes but many stories of failures were untold. See No 2 and No 3.
- Most us do not know what we want in life. We think we will be happier with more money.
Archives of “biases” tag
rss15 Rules for Stock Market Traders-Investors
1. Reward is ALWAYS relative to Risk: If any product or investment sounds like it has lots of upside, it also has lots of risk. (If you can disprove this, there is a Nobel waiting for you).
2. Overly Optimistic Assumptions: Imagine the worst case scenario. How bad is it? Now multiply it by 3X, 5X 10X, 100X. Due to your own flawed wetware, cognitive preferences, and inherent biases, you have a strong disinclination – even an inability — to consider the true, Armageddon-like worst case scenario.
3. Legal Docs protect the preparer (and its firm), not you: Ask yourself this question: How often in the history of modern finance has any huge legal document gone against its drafters? PPMs, Sales agreement, arbitration clauses — firms put these in to protect themselves, not your organization. An investment that requires a 50-100 page legal document means that legal rights accrue to the firms that underwrote the offering, and not you, the investor. Hard stop, next subject.
4. Asymmetrical Information: In all negotiated sales, one party has far more information, knowledge and data about the product being bought and sold. One party knows its undisclosed warts and risks better than the other. Which person are you?
5. Motivation: What is the motivation of the person selling you any product? Is it the long term stability and financial health of your organization — or their own fees and commissions?
6. Performance: Speaking of long term health: How significantly do the fees, taxes, commissions, etc., impact the performance of this investment vehicle over time?
7. Shareholder obligation: All publicly traded firms (including iBanks) have a fiduciary obligation to their shareholders to maximize profits. This is far greater than any duty owed to you, the client. Ask yourself: Does this product benefit the S/Hs, or my organization? (This is acutely important for untested products).
8. Other People’s Money (OPM): When handing money over to someone to manage, understand the difference between self-directed management and OPM. What hidden incentives are there to take more risk than would otherwise exist if you were managing your own assets? (more…)
Indian retail investors tend to lose in stock markets: ISB
Retail equity investors in India systematically lose out to other categories of players because they sell the winning stocks too quickly and hold on to the losing stocks too long, says a study.
It found that individual retail investors in India, numbering 2.02 million – largest in the world – consistently chase a zero rate of return on their stock investments when they make decisions themselves.
The study attributed the recurring losses to these type of investors to the ‘disposition effect’ (selling the winning stocks too quickly and holding on to the losing stocks too long) and ‘overconfidence’ (taking credit for good decisions and attributing bad decisions to luck) for three categories of investors separately. (more…)
11 Rules for Chart Watchers
Rule 1 – If you cannot see trends and patterns almost instantly when you look at a chart then they are not there. The longer you stare, the more your brain will try to apply order where there is none.
If you have to justify exceptions, stray data points and conflicting evidence then it is safe to say the market is not showing you what you think it is.
Rule 2 – If you cannot figure out if something is bullish or bearish after three indicators then move on. The more studies you apply to any chart the more likely one of them will say “something.” That something is probably not correct.
When I look at a chart and cannot form an opinion after applying three or four different types of indicators – volume, momentum, trend, even Fibonacci – I must conclude that the market has not decided what it wants to do at that time. Who am I to tell it what it thinks?
Rule 3 – You can torture a chart to say anything you want. Don’t do it.
This is very similar to Rule 2 but it there is an important point to drive home. You can cherry pick indicators to justify whatever biases you bring to the table and that attempts to impose your will on the market. You cannot tell the market what to do – ever.
Rule 4 – Be sure you check out one time frame larger than the one in which you are operating (a weekly chart for a swing trader, a monthly chart for a position trader).
It is very easy to get caught up in your own world and miss the bigger picture getting ready to smack you. It can mean the difference between buying the dip in a rising trend and selling a breakdown in a falling trend.
Rule 5 – Look at both bars (or candles) and close-only line charts to see if they agree. And look at both linear and semi-logarithmic scaled charts when price movements are large. (more…)
Trading Lessons
- Most of the time, markets are very close to efficient (in the academic sense of the word.) This means that most of the time, price movement is random and we have no reason, from a technical perspective, to be involved in those markets.
- There are, however, repeatable patterns in prices. This is the good news; it means we can make money using technical tools to trade.
- The biases and statistical edges provided by these patterns are very, very small. This is the bad news; it means that it is exceedingly difficult to make money trading. We must be able to identify those points where markets are something a little “less than random” and where there might be a statistical edge present, and then put on trades in very competitive markets.
- Technical trading is nothing more than a statistical game. The parallels to gambling and other games of chance are very, very close. A technical trader simply identifies the patterns where an edge might be present, takes the correct position at the correct time, and manages the risk in the trade. This is, of course, a very simplified summary of the trading process, but it is useful to see things from this perspective. This is the essence of trading: find the pattern, put on the trade, manage the risk, and take profits.
- Because all we are doing is playing the small edges as they occur in the markets, it is important to be utterly consistent in every aspect of our trading. Many markets have gotten harder (i.e. more efficient, more of the time) over the past decade and things that once worked no longer work. Iron discipline is a key component of successful trading. If you are not disciplined every time, every moment of your interaction with the market, do not say you are disciplined.
- It is possible to trade effectively as a purely systematic trader or as a discretionary trader, but the more discretion is involved the more the trader himself is a key part of the trading process. It can be very difficult to sort out performance issues that are caused by markets, by natural statistical fluctuations, by the trading system not working, or by the trader himself. (more…)
Chimpanzees Are Like Stock Traders — They Take Gambles
Humans aren’t the only gamblers in the animal kingdom.
Our closest primate relatives, chimpanzees and bonobos, demonstrate behaviors considered basic to human economics such as delaying gratification and assessing risk, according to new research published Wednesday May 29 in the journal PLoS One.
Though they don’t bet on stock exchanges or casinos, they also have strong emotional reactions to games of chance — like when they are betting on food showing up. They don’t like losing or waiting for payouts, and can even correct their own behaviors based on successes or failures.
“Apes are also experiencing rich emotional reactions in an economic context,” study researcher Alexandra Rosati, of Yale University, said in a statement. “They are making decisions about their most valuable resource, which is food.”
“Even though economists can be quite puzzled about human behavior and what it means, biology suggests that these economic biases have their roots in non-human foraging behaviors,” Rosati said. (more…)
Important Trading Lessons
These are some of those fundamental and undeniable truths, as I have come to understand them over the course of my trading career:
- Most of the time, markets are very close to efficient (in the academic sense of the word.) This means that most of the time, price movement is random and we have no reason, from a technical perspective, to be involved in those markets.
- There are, however, repeatable patterns in prices. This is the good news; it means we can make money using technical tools to trade.
- The biases and statistical edges provided by these patterns are very, very small. This is the bad news; it means that it is exceedingly difficult to make money trading. We must be able to identify those points where markets are something a little “less than random” and where there might be a statistical edge present, and then put on trades in very competitive markets.
- Technical trading is nothing more than a statistical game. The parallels to gambling and other games of chance are very, very close. A technical trader simply identifies the patterns where an edge might be present, takes the correct position at the correct time, and manages the risk in the trade. This is, of course, a very simplified summary of the trading process, but it is useful to see things from this perspective. This is the essence of trading: find the pattern, put on the trade, manage the risk, and take profits. (more…)
HOW BELIEFS DRIVE TRADING
What you believe, consciously or unconsciously, propels your trading in its many directions. It might be so simple a matter as whether you believe a market is going up or down or nowhere. Traders have biases that distort their perceptions and effect their actions, and they need to guard against these with various protections and bias detectors.
Other beliefs are more veiled and ubiquitous. For example, you may consciously intend to make money, but you have a counter impulse that thwarts you due to unconscious beliefs that go against that intention. Perhaps you unconsciously believe that money is the root of all evil, or that rich people are corrupt, or that there isn’t enough to go around and so you shouldn’t be greedy, or that you should be laying up your treasure in heaven, and not on this earth. Perhaps on some level you believe you shouldn’t make more money than your parents.
When you want something, you have to really want it and not be ambivalent about it. It has to be your desire, and not some alien value set by your parents or society. The flower loves the sun, and stretches to receive its rays. The plant loves water and digs its roots deep seeking the object of its desire. If you want to make money trading, you really have to admire money and have good purposes for its use. If you want to be a master trader, you have to be comfortable with that role, and not see trading as wasteful gambling, or an unworthy profession.
Perhaps you believe that you don’t deserve to make money trading, or that you have to work hard for your rewards. Maybe you believe that only the big boys win, that the market is stacked against the ordinary trader. Maybe you believe that it’s impossible to make money in the futures markets or, worse, any market. Maybe you believe it’s possible to make money trading, but it’s not probable that you can keep your winnings. All such ideas run in opposition to easy and effective trading.
Just as insidiously you may doubt that your system really works, or that it won’t work this time. Some traders get superstitious: for example, they believe that they always, or tend to, lose money on Fridays, and so, of course, they do. When any of their superstitious factors occur, somehow they manage to lose.
Strong emotions also get in the way of winning. Underlying each emotion is some belief about what is happening. The interpretations you give events color your reality. Underneath each interpretation is a rock core belief. “That’s just the way it is.” you say. Such a statement flags a belief. Is it really the way it is? Do you feel guilty, scared, angry, or depressed after a losing trade? Perhaps you believe that you shouldn’t lose, that one losing trade implies you can’t trade, that one losing trade portends many more losing trades, or that you’ve jinxed yourself for the rest of the day or week.
Equally or possibly even more important are the positive conscious and unconscious beliefs that you hold about trading and investing.
To begin with, to do anything well, you need to believe that it can be done, that you can do it, and that you deserve to do it. You’re in trouble if you doubt any of these three. Your trading is at risk if you don’t firmly believe that money can be made trading, that you can make money trading, and that you deserve to make money trading. (more…)
Price, The Conscious Investor
John Price, author of The Conscious Investor: Profiting from the Timeless Value Approach (Wiley, 2011), began his career as a research mathematician and for thirty-five years taught math, physics, and finance at universities around the world. He then morphed into an entrepreneur, developing stock screening software that emulates Warren Buffett’s investing strategies. And, as is evident from this book, he didn’t neglect his writing skills. He proceeds with the analytical precision of a mathematician but with the facility and clarity of a careful wordsmith.
Price describes over twenty methods of valuation. He explains the circumstances in which each method is most appropriate. He also evaluates each method’s strengths and weaknesses.
Here I am going to confine myself to describing the screen that underlies Price’s own investing system. He focuses on earnings forecasts, offering objective methods in place of the strategies of analysts, which are tainted with behavioral biases. Critically, he screens to find companies that are actually amenable to growth forecasts. They share three characteristics. “The first two, stable growth in earnings and stable return on equity, are based on histories of financial data taken from the financial statements. The third one, strong economic moat, is based on the ability of the company to protect itself from competitors.” (p. 292) Since many readers will be familiar with Warren Buffett’s notion of moats, I will discuss only the first two characteristics and how to measure them.
Price developed a proprietary function called STAEGR which “measures the stability or consistency of the growth of historical earnings per share from year to year, expressed as a percentage in the range of 0 to 100 percent. … STAEGR of 100 percent signifies complete stability, meaning that the data is changing by exactly the same percentage each year. The function has the feature of adjusting for data that could overly distort the result, such as one-off extreme data points, negative data, and data near zero. It also puts more emphasis on recent data.” This function is “independent of the actual growth. This means that whether a company has high or low stability of earnings is independent of whether the earnings are growing or contracting. In this way the two measures, stability and growth, complement each other in describing qualities of historical earnings.” (p. 294) (more…)
3 Biases That Affect Your Trading
Van K. Tharp mentioned there are 3 biases that will affect one’s trading:
1) Gambler’s fallacy bias
People tend to believe that after a string of losses, a win is going to come next. Take for example that you are playing a game of coin tossing with a capital of $1000. You lost 3 bets in a row on heads and cost you $100 each bet. What will you bet next and how much would you stake?
It is likely you will continue to bet on heads and with a higher stake, say $300. You do not ‘believe’ that it can be tails consistently. People fail to realize coin tossing is random and past results do not affect future outcomes.
Traders must treat each trade independently and not be affected by past results. It is important that your trading system tells you how much to stake your capital which is also known as position sizing, so that the risk-reward ratio will be optimal.
2) Limit profits and enlarge losses bias
People tend to limit their profits and give more room to losses. Nobody likes the feeling of losing. Most investors tend to hold on to losses and hope their investments will turn around soon, and they will be happy if their holdings break even. However, chances are that they will amount to greater losses. On the other hand, if they are winning, most investors tend to take profits early as they fear their profits will be wiped out soon. Thereafter, they regretted that they didn’t hold a little longer (sounds familiar?). (more…)