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Critical Thinking 101

One of the issues that bedevil us as both humans and traders is our ability to think clearly and rationally about subjects. We are prone to making snap judgments based upon the flimsiest of evidence. I get any and all manner of rubbish sent to me – some of it by people who should know better. There is nothing like someone who knows how you trade and your philosophy sending you research from stockbroking firms. I had to point out that to use it as toilet paper I would have to print it out and that would be a waste of ink, electricity environmentally unfriendly and scratchy.

However, there are times when I get sent material that is even stupider than broker research. Consider the image below since it serves as a wonderful illustration as to how stupid people can be and how lacing in critical judgement most are..

Screen Shot 2015-10-19 at 9.33.42 pm

This little piece tries to convey the central premise that cancer rates are increasing. Since such an increase seems unnatural  someone or something has to be to blame (this is the argument of personal incredulity). In this instance the causative agent is apparently Monsanto. The leap in logic is that there are more chemicals about, chemical cause cancer and Monsanto produces chemicals. Therefore Monsanto and its kind are either directly or indirectly to blame for the rise in the number of cancers being diagnosed. The same graphic has been reproduced to support a variety of issues, ranging from vegetarianism to anti vaccination. The unfortunate thing about this graphic is that the gullible of the world will both absorb it without question and repeat it as fact. Even if you are not so gullible it will still reside within your subconscious as one of those things you sort of think is true.

Most don’t get past simply accepting the image as true. In some instances a lack of cognitive ability can be to blame, some people are just too stupid to be able to think. Others are simply stuck in a word of self-fulfilling biases where any evidence that supports their internal dogma is seized upon and amplified. However, a little bit of critical thinking can go a long way in making sensible judgments about “facts” you are presented with.

Screen Shot 2015-10-27 at 11.32.01 AMAnyone who has sat through first year stats will tell you that the thing that is drummed into everyone is correlation does not imply causation and this is the first problem with such graphics. Simply because two things travel in tandem does not mean that one causes the other. For example I could present evidence to show that the rates of cancer quoted are related to the overall increase in the Dow since 1900. As the Dow has increased from 60 points in 1900 to over 17,600 so too have rates of cancer. Spurious correlations are the bread and butter of conspiracy nuts and journalists.

To fully understand such graphics you do need to do a bit of thinking and instead of jumping to a conclusion you need to ask what other things might be happening. The most obvious change in human health since 1900 has been an increase in life span. In 1900 the average life expectancy in the US was 47 years, at present it stands at 78 years. This gives us a clue to what might be causing the increase. Cancer is primarily a disease of ageing, the longer cells have to replicate the more time there is for errors to creep in. The older we get the the greater the potential for cancers to occur. However, there is a second element at play here and that is one of diagnosis. In the past a great many cancers went undiagnosed simply because imaging technology did not exist. For example the rise in acoustic neuroma’s seems to be the result of improved scanning via MRI’s. This is undoubtedly true for a variety of other cancers as well.

All of a sudden what seemed to be an obvious causation has come apart with a simple bit of critical thinking. So what is the relevance of this to trading?

As I said I get sent all sorts of odd stuff and one of the things I was sent was this piece below –

Eley Griffiths Group calculates the local market’s equity risk premium each quarter. At present it sits at 6.35%, slightly more attractive than the June quarter setting. The Australian sharemarket continues to offer equity investors ample reward for the extra risk over bond returns. Local equities are a BUY at current levels. The relative outperformance of the XSO versus the ASX 100 looks set to continue, if EGG’s interpretation of current PE differentials holds true. At the time of writing, the FY16 PE ratios of small and big caps were at parity at ~ 14.8x. History has taught this manager a thing or two and one dyed- in-the-wool rule is that the market doesn’t buy small caps at sizable (15-20%) discounts to big caps. Counter intuitively, investors buy small caps at PER parity and continue this until a full blown premium differential is in place.

I have emphasized the passage that caught my eye since it makes a direct assertion as to the relative performance of two instruments. And this relative performance is the basis upon which the argument hangs (the rest is fluff). On face value this statement seems to make sense, small caps are generally lower in price, therefore they offer the potential for more leverage. Hence, they make more money. It sounds like a compelling narrative but a quick comparison between the two indices in question shows that it is not correct. The XSO or Small Ords has underperformed the XTO or S&P/ASX 100 for several years.

Screen Shot 2015-10-27 at 11.24.52 AM

When looking at relative performance it is important to start from the old maxim that one swallow does not a summer make. That is the more data you have the more veracity your conclusions will have. Looking at performance over small time frames is meaningless. What is more worrisome is that that someone will read it and naturally accept that it is true without questioning its veracity. They may even make an investment decision based upon what they have accepted as true. Unfortunately, the investment industry is full of statements that dont hold water. They range from you will never go broke taking a profit through to averaging down is a brilliant idea. As you would expect none of  these hold up to scrutiny – data is a very harsh task master.

The rush to accept information from any perceived higher authority is a problem for traders and investors alike. Just because something sounds true does not mean that it is true – even the most logical sounding proposal may in fact simply be rubbish when subject to scrutiny. The moral of the story is to accept nothing at face value – think about everything you are told.

 

 

Is Half A Story Better Than No Story

A recent email exchange with someone who manages money professionally has lead to me to repost this piece I wrote some time ago. During the exchange I couldn’t convince them that not losing money was more important than trying to make it. It has always intrigued me how hard it is to get this point across to people. The notion of capital preservation along with only being in the market when the market tells you to enter are for me the two cornerstones of equities trading yet they are almost impossible to convince people of. And I am quite certain whilst I am up at the AIA Conference next week I will undoubtedly encounter more folks who simply dont get it.

The profession of trading or investing is an intriguing one . To the outside observer who comes from a discipline outside of finance or economics so much of what is taken for fact seems to be little more than half baked homilies that have been handed down from generation to generation. As with most narratives there seems to be scant evidence for things that are accepted as true.

Consider the chart below which has been taken from Funds Focus.

This image shows that if you had missed the best days in the All Ordinaries Accumulation Index for the period quoted that your performance would have dropped dramatically. The implication is therefore that you should stay continuously investing. In most cases this sort of image is used as justification to simply buy and hold. Such images are standard fare in both financial planning and funds management marketing. The market and the time period may changed but the basic message remains the same.

As initially compelling as this image may be it doesn’t actually convey the entire story of investing in a market. To get a sense of the entire story you need to look at the notion of worst days – what happens to your returns if you set out to manage your exposure to those periods when the market begins to swing down.

The notion of missing days is extremely impractical since it requires a remarkable fidelity in ones timing strategy. However, it is possible to generate techniques that can miss the worst months that a market may go through. The chart above looks at what happens to returns if you have missed those periods where the All Ordinaries Index went down 2.5% or more versus being in the market when the market climbed 2.5% or more. For the period quoted if we had missed the so called good times our return would have been -83.26%, if we had simply held the index our return would have been 91.71%. If we stopped the investigation at this point it would seem to justify the notion of being in the market all the time since being out of the market had damaged our return. Yet, this is not the entire story because if we had missed the bad periods our return is 3079.50%.

The reason for this difference in return is simple. Losses matter more than gains, a 10% loss cannot be made up by a 10% gain – it takes 11.1% to return to your starting point. The unyielding harshness of this can be seen in the chart below.

All good traders know that that the preservation of capital is far more important than the making money. It is also one of the few things within that control of traders. The return we generate is dictated by forces outside our control but we can control how much is lost on individual positions. We can only make whet the market is willing to give us but we can decide how much we are willing to lose on any given investment.

The differential I generated between missing good periods and bad periods is unrealistic but it does serve to illustrate that the notion of being in the market all the time is extremely flawed  and in part is explanation for the appalling rate of return of domestic fund mangers. What is of more importance to those investing in markets is to understand that losing money is more important than making it. Trading or investing is largely about being able to play a good defence. There are very few absolutes in markets but one thing is clear. If you have no money you cannot play and whilst being seduced by some of the childish homilies that abound in markets might not send you completely broke it will guarantee that your returns are ordinary.

 

 

Tantrum Of The Week

I was going to drop this into the email of the week category but it seemed to be more of a sook of the week sort of thing. Unfortunately, this one wasn’t sent to me so I had to read it over LB’s shoulder but its contents are more than worthy pf repeating. Our erstwhile correspondent stated that the had some success in the market but really was an overall loser. The reason he was a loser was because the markets were rigged by giant hedge funds who were set up to steal of ordinary investors and the somewhat sharp move down on Wednesday was proof of this. He didn’t see any way to be profitable other than to understand price action (WTF) so was quitting.

This email also dovetails neatly into a discussion we have been having on the Mentor Program Forum which had drifted into the nature of personal responsibility and its role in achievement. My view is that people who are successful at whatever they do have an internal locus of control and their actions and vocabulary reflect this. For example saying “I can’t” places the locus of control outside of your sphere of influence. Whereas, saying “I won’t” reflects an internal locus of control – you are simply admitting that you won’t do something and this is very confronting for people. For example when people say they cant lose weight, what they are really saying is I wont but they dont want to admit this. Their failing has to be the result of some external agency such as a mythical metabolic condition.

Stating that the market is rigged is no different since it places control in the hands of an unseen external agent and therefore away from the individual. The individual is therefore automatically resolved and all responsibility for their failings. By default they have adopted an I cant mentality.

Over the years I have seen this repeatedly – traders find out that the markets are not an instant ticket to massive wealth and therefore give up. In many ways though this is no different to the tin foil hat wearers of the world who see conspiracies everywhere. Research into conspiracy theories by Joseph E. Uscinski and Joseph M. Parent and presented in their 2014 book American Conspiracy Theories (Oxford University Press) found that –

“researchers have found that inducing anxiety or loss of control triggers respondents to see nonexistent patterns and evoke conspiratorial explanations” and that in the real world “there is evidence that disasters (e.g., earthquakes) and other high-stress situations (e.g., job uncertainty) prompt people to concoct, embrace, and repeat conspiracy theories.”

I would see losing money in the market is an anxiety inducing event. However, my feeling about why poor traders react this way does drift back to a very uncharitable point of view. They simply cannot do it and are therefore looking for someone else to blame for their failings. To me it is no different to football fans who blame the referee for their teams weekend defeat. You are not good enough – man up and admit it.

Notwithstanding our authors obvious lack of moral fibre there is another issue within their email that bears closer scrutiny and that is the notion that the move on Wednesday was somehow an outlier that could have only occurred because of market manipulation. Consider the chart below on which I have marked a series of moves with red and blue circles.

Ords Moves Highlighted

The immediate question I would pose is how is the move in red different  from those in blue? Other than it being a bearish move and the others bullish there is no different, nor is it different from any of the other nasty down days that the market has experienced. I can only posit that this move was different from our authors perspective because it caused our author to lose money because he was caught in an expectation that price only ever goes up and if price goes down when I am expecting it to go up then the market must be rigged. It has to be rigged because I am not stupid enough to be on the wrong side of a move. Again, the notion of failure is caused by an external event not an internal inadequacy.  We are back to our I wont versus i cant distinction.

However, the recent price action of the market does bear closer examination to see whether this move is an outlier worthy of tagging as the sign of collusion among unseen agents. the chart above shows the recent support/resistance lines in the market. It shows that for some time the market has simply been bouncing around doing very little. It may have an extreme up day or it may have an extreme down day but in the overall scheme of things it has not gone very far.  If the market was being savagely manipulated then it would show short term performance that was divergent from other markets in the world. If we look at the performance of a handful of other markets over the past three months we see that this is not true. Since late April world markets have been very ordinary.

Screen Shot 2015-05-08 at 5.45.13 am

If we expand out the time horizon to five years we can see that the local market has been a consistent underperformer – this is simply the nature of the market at present.

Screen Shot 2015-05-08 at 5.47.47 am

It is difficult for people who are unsuccessful at something to admit that they are unsuccessful, it is far easier to blame someone else for your failings. To do so is in many ways the default setting for the bulk of the population. Failing is a natural state of being for all of us – we all fail at something at some point in our lives. But very few have the courage to admit that their failings are the result of internal shortcomings in either skill or emotional maturity.

I will leave the final words to LB’s seven year daughter who seems to be the fountain of all wisdom as most kids are. LB was telling a very heartfelt story of a time in her life at school when one of her friends offered her support in a time of need. She had set the scene and was just about to deliver the wisdom that her friend had imparted, in the manner of a parent offering an important life lesson when her daughter pops up and yells…he said suck it up ya big baby…..

Email Of the Week

It has been sometime since we had an email of the week. So I offer the following without comment.

YES HI LOUISE

MY name is ………..

I am a researcher    YES I research  gaming   also   see my site
www.……….       it is different  opportunity

I just move to ……    two months ago    I just purchase  my new
RESONATOR  !    20 years research     six  month to build
200 hours    work  hand made    you can learn much information about
orgone energy   via internet      see

http://www.orgonics.com/whatisor.htm

I only  have ny RESONATOR  four weeks  now  I love to  use my advanced
  testing checking    with resonator    for free
with you  in stock market    I have not  worked  the stockmarket before
just test two or three     if interested   let me know !

thanks ………

This email was accompanied by 16 others in quick succession…….

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.