The following excerpts are from Stephen Jay Gould’s Full House.
People under assault, and hopelessly overmatched, often do the opposite of what propriety might suggest: they dig in when they ought to accommodate. We call this behavior siege mentality. Davy Crockett, Jim Bowie, and Co. won posthumous immortality by their intransigence at the Alamo, but an honorable surrender (given their hopeless situation and the certainty of carnage with continued fighting) might have secured the more worldly privilege of telling good war stories over a beer at a Texan bar (for independence from Mexico would have been won in any case) some twenty years later. The embattled traditionalist [buy and holder] must therefore stand his ground on the right tail of his natural habitat. He must adopt a siege mentality and dig in to protect his own restricted turf. The right tail, he must now admit may be small and merely consequential. But grant me, he pleads, this last potential natural comfort: ‘May I not at least be a king in my own restricted castle?’ Give me, then, at least, this one remaining solace in a parody of a fine old song: ‘It had to be me, wonderful me; it had to be me.’ Let me, in short, live like Pio Nono (the nineteenth-century Pope Pius IX). My predecessors held temporal power over much of Europe. I once ruled a good part of Italy, though I am now confined to a tiny principal – Vatican City – within Rome. But at least my rule here is absolute and I can proclaim my infallibility!
TurtleTrader comment: Gould makes the clear point on human psychology: Most people do not want to reach outside their knowledge area (or comfort zone). What most people want (at often the expense of their best interest) is their own little kingdom. Not a good way to be if you desire to profit from the market.
A potential for inherent progress provides no guarantee of realization in actuality. The radical contingency of all history can intervene in a thousand potential ways. A capacity for technological accumulation does not guarantee that all cultures will avail themselves of this potentially mixed blessing. In fact, several great societies have made conscious decisions not to pursue technological progress to the inevitable destruction of an old order. At a crucial point in the history of human life, imperial China decided to scrap the technology of interoceanic shipping and navigation that, if pursued, might well have converted the central historical theme of European westward expansion to an alternative tale of Oriental eastward exploration in the New World. In the early 1640s, after a century of relative openness to Western inventions, especially to the musketry that permitted their assumption and consolidation of power, Japan’s ruling Tokugawa shogunate severed all future accumulation and banned most of what had been imported. So complete and sudden was the cutoff that Japanese inhabitants of various trading cities established abroad were not even allowed to return home. All Western trade was reduced to the merest trickle. Only two Dutch ships could arrive each year. They could dock only at Nagasaki, and all Dutch traders had to live on the artificial island of Dejima, connected to the rest of Nagasaki by a narrow and easily guarded causeway.
TurtleTrader comment: There are many reasons when people are faced with better opportunities (or strategies) they run the other direction. Good traders take advantage of that weakness. Even if you think you are avoiding the fight, you still lose. The fact that one doesn’t want to face reality doesn’t make reality go away.
The Innovator’s Dilemma by Clayton M. Christensen is a great read for trend followers. Christensen recently offered in an interview:
They were looking at the book [Innovator's Dilemma] for answers rather than for understanding. They were saying ‘tell me what to do’ as opposed to ‘help me understand so I can decide what to do.’…[Wall Street analysts] are theory-free investors. All they can do is react to the numbers. But the numbers they react to are measures of past performance, not future performance. That’s why they go in big herds. Wall Street professionals and business consultants have enshrined as a virtue the notion that you should be data-driven. That’s at the root of the inability of companies to take action in a timely way.
Christensen clearly outlines a key tenet of the trend following mindset. Trend following is never based on having all the data. It’s based on odds and reaction. Think about it. If you look at a stock such as Yahoo and witness its great rise and decline you can say ‘you should have bought here and sold there’. But isn’t that 20/20 hindsight? No, you simply needed a trading plan of attack before the great rise up and great decline down.
What Christensen is driving at is the notion that you must be able to make decisions in the face of not knowing how the trend will look when it’s all over. You must have a plan to act early before trend direction is obvious to the masses. You must be set and ready to go (and entered) long before the CNBC watchers decide the trend is underway and jump on. Those people are always a day late and a dollar short. Those people are the herds Christensen alludes to. Those people don’t make the money, they lose it. And given that trading is a zero-sum game, the money that those people lose goes directly to the other people with the plans of attack designed to win their losses.
“We know that prices move up and down. They always have and they always will. My theory is that behind these major movements is an irresistible force. That is all one needs to know. It is not well to be too curious about all the reasons behind price movements. You risk the danger of clouding your mind with non-essentials. Just recognize that the movement is there and take advantage of it by steering your speculative ship along with the tide. Do not argue with the condition, and most of all, do not try to combat it.”
“The market reflects all the jobber knows about the condition of the textile trade; all the banker knows about the money market, all that the best-informed president knows of his own business, together with his knowledge of other businesses; it sees the general condition of transportation in a way that the president of no single railroad can ever see. It is better information on crops than the farmer or even the Dept of Agriculture. In fact, the market reduces to a bloodless verdict [THE PRICE] all knowledge based on finances, both domestic and foreign.”
In response to questions concerning his opinion on where individual markets may be headed, Jerry Parker had this to say:
I don’t know nor do I care. The system that we use at Chesapeake is about the market knowing where it’s going.
“What interests me is the question of how humans learn to live with uncertainty. Before the scientific revolution determinism was a strong ideal. Religion brought about a denial of uncertainty, and many people knew that their kin or their race was exactly the one that God had favored. They also thought they were entitled to get rid of competing ideas and the people that propagated them. How does a society change from this condition into one in which we understand that there is this fundamental uncertainty? How do we avoid the illusion of certainty to produce the understanding that everything, whether it be a medical test or deciding on the best cure for a particular kind of cancer, has a fundamental element of uncertainty?”
Market Commentary that addresses heuristics:
…we often get the recurring question: why is your method successful? This is especially the case when there is so much fundamental information available to use in making decisions. We think that our success has been based on simplicity; nevertheless, there often is a bias by some investors away from the simple manager in favor of those who discuss and try to account for the complexity of markets. To some, simple means unsophisticated; but there is a growing body of research work which suggests that simple methods of decision-making actually outperform their more complex alternatives. This certainly may seem counter-intuitive; but in a complex world where decisions have to be made with limited information and face real world time constraints, there may not be the ability to optimize over all possible alternatives. Under the real life situations faced by a trading firm, there is a premium on “fast and frugal” decision-making or heuristics. Fast decision-making is often based on just a few cues or inputs that may seem relevant. There is actually value in not using too much information. Researchers have found through testing that simple decision rules often can perform as well or better than more sophisticated forms of decision-making – especially when there is a high degree of uncertainty… There is a constant barrage of information; but often this information can be conflicting and, in some cases, does not come out with the frequency that we would like. For example, monetary policy can serve as a simple case. There are only a limited number of Fed meetings a year; however, this is supposed to help us infer the direction of interest rates and help us manage risk on a daily basis. How do you manage risk in markets that move 24 hours a day, when the fundamental inputs do not come frequently? In the grain markets, crop reports are fairly limited, and demand information comes with significant lags, if at all. How can this information be best incorporated in the daily price action? Under these types of conditions, simple approaches, such as following prices, may be better. In reality, our desire for effective decision-making is based on a simpler cue. Is the market going up or down? Has each position lost a predetermined amount of capital on a trade? We do not worry about trying to decipher all of the particulars of the market when action is required. In that case, the trend may be more than sufficient as a cue of what to do. It may actually be preferred to other information. Something to think about the next time you listen to a manager talking about the complexity of his thought processes as the indicator of his expertise as a manager. Signals are built into the market price…
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Michael Mauboussin offers insight on memes.
Download the white paper above.
Consider this excerpt from Michael Mauboussin:
Changes in our world are increasingly the result of cultural evolution, not genetic evolution. An understanding of the basic mechanism of memetic evolution provides an intelligent investor with a foundation to contemplate technological change and self-awareness of the (often hidden) assumptions that underlie their investment process.
We agree with Mauboussin on the importance of memes.
We don’t agree with Mauboussin’s use of the term stock picking, but that is a quibble of his overall work.
“The biggest secret about success is that there isn’t any big secret about it, or if there is, then it’s a secret from me, too. The idea of searching for some secret for trading success misses the point.”
Michael J. Mauboussin, and with a little help, explains how rules should define your trading:
One of the characteristics of a complex system is that highly variable outcomes emerge from simple rules. Unless you deliberately replay a chess game, you’ll never see the same game twice. Herein lies the key to resolving the short-term versus the long-term tension. Companies should develop long-term decision rules that are flexible enough to allow managers to make the right decisions in the short term. In this way, the company is managing for the long run even when it has no information about what the future holds. No company knows how the business landscape will develop just as chess players don’t know how the board will develop‹but decision rules provide action guidelines no matter what happens. Kathy Eisenhardt and Don Sull call this strategy as simple rules. They argue that companies, especially in fast-changing markets, should not embrace complex strategies but rather adopt and stick to a few straightforward, hard-and-fast rules that define direction without containing it. Eisenhardt and Sull specifically suggest five types of rules:
1. How-to rules spell out key features of how a company should execute a process. It answers the question: What makes our process unique?
2. Boundary rules focus managers on which opportunities they should pursue and which are outside the pale.
3. Priority rules help managers rank the opportunities they accept.
4. Timing rules synchronize managers with the pace of opportunities that emerge in other parts of the company.
5. Exit rules help managers decide when to pull out of yesterday’s opportunities. They argue that a company should have somewhere between two and seven rules, that young companies typically have too few, and that more mature businesses have too many. A decision rule to maintain accounting integrity (i.e., to avoid managing earnings per share versus managing the business) might also help reduce undue short-termism.
This strategy as simple rules approach is not only strongly analogous with successful chess playing, but it also resonates with other complex adaptive systems. Most important, it puts to rest the nonproductive debate about whether companies should manage for the short or long term. Companies that embrace simple rules can manage both for the next quarter and the next quarter century.
One of the common struggles in new and experienced traders is outlined in this excerpt from James O’Shaughnessy:
We also prefer the complex and artificial to the simple and unadorned. We are certain that investment success requires an incredibly complex ability to judge a host of variables correctly and then act upon that knowledge. Professor Alex Bavelas designed a fascinating experiment in which two subjects, Smith and Jones, face individual projection screens. They cannot see or communicate with each other. They’re told that the purpose of the experiment is to learn to recognize the difference between healthy and sick cells. They must learn to distinguish between the two using trial and error. In front of each are two buttons marked Healthy and Sick, along with two signal lights marked Right and Wrong. Every time a slide is projected they guess if it’s healthy or sick by pressing the button so marked. After they guess, their signal light will flash Right or Wrong, informing them if they have guessed correctly. Here’s the hitch. Smith gets true feedback. If he’s correct, his light flashes Right; if he’s wrong, it flashes Wrong. Since he’s getting true feedback, Smith soon gets around 80 percent correct, since it’s a matter of simple discrimination. Jones’s situation is entirely different. He doesn’t get true feedback on his guesses. Rather, the feedback he gets is based on Smith’s guesses! It doesn’t matter if he’s right or wrong about a particular slide, he’s told he’s right if Smith guessed right and wrong if Smith guessed wrong. Of course, Jones doesn’t know this. He’s been told there is a true order that he can discover from the feedback. He ends up searching for order when there is no way to find it. The moderator then asks Smith and Jones to discuss the rules they use for judging healthy and sick cells. Smith, who got true feedback, offers rules that are simple, concrete, and to the point. Jones, on the other hand, uses rules that are, out of necessity, subtle, complex, and highly adorned. After all, he had to base his opinions on contradictory guesses and hunches. The amazing thing is that Smith doesn’t think Jones’s explanations are absurd, crazy, or unnecessarily complicated. He’s impressed by the brilliance of Jones?s method and feels inferior and vulnerable because of the pedestrian simplicity of his own rules. The more complicated and ornate Jones’s explanations, the more likely they are to convince Smith. Before the next test with new slides, the two are asked to guess who will do better than the first time around. All Joneses and most Smiths say that Jones will. In fact, Jones shows no improvement at all. Smith, on the other hand, does significantly worse than he did the first time around, since he’s now making guesses on the basis of the complicated rules he learned from Jones.
Process is Key
A young boy traveled across Japan to the school of a famous martial artist. When he arrived at the dojo he was given an audience by the sensei. >What do you want form me?, the master asked.
I wish to be your student and become the finest karateka in the land, the boy replied. How long must I study? Ten years at least, the master answered. What if I studied twice as hard as all your other students? Twenty years, replied the master. Twenty years! What if I practice day and night with all my effort? Thirty years, was the master’s reply. How is it that each time I say I will work harder, you tell me that it will take longer?, the boy asked. The answer is clear. When one eye is fixed upon your destination, there is only one eye left with which to find the way.
The ability to make decisions when faced with an assortment of opportunities and choices is central to Trend Following success. The following links must be read by all:
We have long posted decision-making links for trading. The following excerpts from “Subconsciously: Athletes May Play Like Statisticians”, by David Leonhardt of The New York Times continues that tradition:
When Justine Henin-Hardenne rips a cross-court forehand at the Australian Open or Tom Brady, the New England Patriots quarterback, dodges an onrushing defender, each looks like the very definition of living in the moment. Like other great athletes, they often appear to rely on speed, strength and lightning-fast reactions. There seems to be little time for highly advanced quantitative analysis that weighs current observations against past experiences to suggest a plan of attack. But this kind of analysis is precisely what the human brain does when facing a physical challenge, according to a study by two European scientists published in the current issue of Nature. The more uncertainty that people face – be it caused by wind on a tennis court, snow on a football field or darkness on a country highway – the more they make decisions based on their subconscious memory and the less they depend on what they see.
The great trend followers follow this path. It can be described, as “practice makes perfect”. However, people have long known about these concepts:
In everyday life, of course, people have been using the ideas underlying Bayesian analysis since well before it became the vogue in science labs, or even before Thomas Bayes, an 18th-century British minister and mathematician, formalized the method in a paper that was published two years after he died. When crossing a street, people rely on both what they see and what they remember about the speed of cars on similar roads. When deciding whether to take a sick child to a doctor, parents consider the current symptoms as well as the child’s history and their general knowledge of illness. “The human brain knows about Bayes’s rule,” said Konrad P. Körding, a postdoctoral researcher…
Last year Moneyball introduced statistical thinking for baseball to the masses. Now Wayne Winston and Jeff Sagarin are applying “numbers” to basketball in a way people will not expect:
This is the exact type of “thinking” that goes into trend following success.