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“A man should not strive to eliminate his complexes but to get into accord with them: they are legitimately what directs his conduct in the world.”

Sigmund Freud

Commentary & Analysis

Clinging to beliefs is bad for a trading account

1. something believed; an opinion or conviction: a belief that the earth is flat.

2. confidence in the truth or existence of something not immediately susceptible to rigorous proof: a statement unworthy of belief.

3. confidence; faith; trust: a child’s belief in his parents.

4. a religious tenet or tenets; religious creed or faith: the Christian belief.

A “belief,” in most cases, is a prerequisite for a trade. No matter what it is we define as our trading edge—fundamental analysis, technical analysis, planetary movement, or back pain— we must have some degree of belief in success, no matter how infinitesimal the probability, or the trigger will never be pulled.

A common trader’s malady which leads to a trigger never pulled is “paralysis of analysis.” This disease flows from the human-like desire to find certainty in a place certainty never exists—the market. If you have traded for a while, I am sure you have been afflicted with the dreaded POA more than once—I have. The remedy for POA is to remember trading is a probability bet; nothing more and nothing less. It sounds so simple, but it is not an easy proposition given the hardwiring of the human mind.

To summarize: Our desire for certainty overlaid with our emotional brain leads to a particular problem for traders—clinging to beliefs.

It’s the too much clinging which leads to the demise of a trading account.

So why do we cling to beliefs?

Karl Popper was a German philosopher whom I began reading back in 1988 thanks to finding reference to him in Mr. George Soros’ great book: “The Alchemy of Finance.” Mr. Popper’s arguments have impacted me ever since and I think helped me become a better trader—as I define it.

Popper referred to the black swan in his 1953 essay on The Problem with Induction. Induction application in the financial world is best known as “back testing.” With the gift of hindsight we now all know how dangerous back testing can be in the real world. Reading Popper gives one a deeper understanding of why we cling to beliefs so tightly and assume we can confidently project our expectations into the future and be confident we will be right.

Popper was fond of David Hume and used his reasoning for much of the basis of his argument about induction, carrying it further. Popper wrote:

But Hume held, at the same time, that although induction was rationally invalid, it was a psychological fact, and that we all rely on it.

Thus Hume’s two problems of induction were:

1) The logical problem: Are we rationally justified in reasoning from repeated instances of which we have had experience to instances of which we have had no experience?

Hume’s unrelenting answer was: No, we are not justified, however great the number of repetitions may be. And he added that it did not make the slightest difference if, in this problem, we ask for the justification not of certain belief, but of probable belief. Instances of which we have had experience do not allow us to reason or argue the probability of instances of which we have had no experience, any more than to the certainty of such instances.

2) The following psychological question: How is it that nevertheless all reasonable people expect and believe that instances of which they have had no experience will conform to those of which they have had experience? Or in other words, why do we all have expectations, and why do we hold on to them with such great confidence, or such strong belief?

Hume’s answer to this psychological problem of induction was: Because of custom or habit; or in other words, because of the irrational but irresistible power or the law of association. We are conditioned by repetition; a conditioning mechanism without which, Hume says, we could hardly survive.

Okay! I realize this is getting thick, hang in there, almost there.

Popper agreed with the first part of what Hume talked about; the logical problem. But neither Popper, nor Bertram Russell, a disciple of Hume, could accept the irrationality of the second part—the psychological problem.

It is here were we get to the black swan.

Popper posed that yes we must use experience of past instances to advance our knowledge but we must accept the fact that just because so many past instances were effectively consistent, or the same, it does not therefore mean a theory based upon those past instances has been proven. The reason he says this is because there may be some future instance out there that invalidates all that has come before it, and it only takes one such instance to do that. Therefore, all theories can be falsified, but they cannot be proven simply by past experience.

…Or in other words, from a purely logical point of view, the acceptance of one counter instance to the view that, “All swans are white,” implies the falsity of the law “All swans are white”—that law, that is, whose counter instance we accepted. Induction is logically invalid; but refutation or falsification is a logically valid way of arguing from a single counter instance to—or, rather, against—the corresponding law.

This logical situation is completely independent of any question of whether we would, in practice, accept a single counter instance for example, a solitary black swan in refutation of a so far highly successful law. I do not suggest that we would necessarily be so easily satisfied we might well suspect that the black specimen before us was not a swan. And in practice, anyway, we would be most reluctant to accept an isolated counter instance. But this is a different question. Logic forces us to reject even the most successful law the moment we accept one single counter instance.

Thus, the theory, or law, that all swans were white was falsified once a black swan living in Australia was discovered. Till then, everyone knew all swans were white. Done deal!

Of course everyone knew Triple AAA-rated tranches of securities were safe. Everyone knows municipal bonds will be fine because the default rate has always been low in the past. Everyone knows that gold is the only real money. Everyone knows inflation is a monetary phenomenon. Everyone knows the dollar must go down eventually. Everyone knows that China will rule the world soon….I think you get where I am going here.

We could go on and on into infinitum with what everyone thinks they know. But interestingly, the things we seem to think we know often don’t even have the consistent instances of induction in their favor. We cling to ideas in the financial world that have been falsified before but seem to gather a second life. This isn’t even close to the word logical.

Happy New Year.