I’ve been thinking and writing a lot about uncertainty lately—and about making decisions with incomplete information. Over the past two years, we’ve all had to make decisions in an uncertain environment as the world struggles with Covid. There are many other lessons and parallels from other areas of life, but I want to focus this discussion down on financial markets. Rethinking black and white categories can give traders a better view of reality, a more accurate grasp on truth, and likely improve bottom line trading performance.
The nature of trading decisions
Making money, over the long run, is hard in financial markets. One of the major reasons is the nature of the decisions we must make. Consider these points:
- Market decisions are always made with incomplete information. You never know everything; even the reasons behind past moves are obscure, and you certainly never know the capabilities or intentions of other players in the market.
- Market decisions have to be made at the right time. Doing the right thing at a time that is just slightly wrong is usually the same as doing the wrong thing! Of course, this varies depending on your timeframe. For daytraders, it’s obvious: you have to make decisions and act in seconds. For longer-term traders, there’s still a special quality to when decisions must be made and implemented.
- Market decisions always carry consequences. This can vary over the course of your trading career, but one of the keys to trading is carrying the right kind and amount of risk. If you’re doing this, no decision is truly insignificant. Everything matters.
- Every decision carries an emotional charge that traders must learn to deal with. No human decision is made with pure reason–emotions always, for better or worse, play their part.
Now, this landscape is probably not truly unique in human experience, but it’s unusual enough to likely be unique to most individuals—you’ll likely not encounter similar conditions anywhere else in your life. (Combat is one of the few immediate parallels that spring to mind.)
It’s not either-or
We tend to think in black/white, true/false categories. There’s good reason for this: doing so is the foundation of logic and is responsible for much of the success of science and learning in recent centuries. You could argue (as Karl Popper certainly did) that the essence of scientific thinking is negation; if we can find contradictory information we can prove an idea to be not true.
For instance, consider the statement “all cats have four legs”. A single observation of a cat with three legs would prove this statement to be incorrect. While this is a trivial example, the idea of finding a “counterexample” is deeply rooted in the way we think about the world, and it’s certainly valid and useful.
But not all statements are as clear-cut. (Which is why we know we must be careful with words like all, always, without exception, etc.!) Statements such as “most cats have four legs” or “many cats have four legs” require a different framework to evaluate.
Now, this seems obvious, but when we move to the real world and financial markets things get thornier.
Conflicts in the market
Consider the recent decline in stocks. As the chart on this page shows, the Russell 2000 (a smallcap index that is often reflective of risk appetite) broke to new highs and then failed decisively. Every major US index also collapsed, most ex-US global markets fared even worse. (Despite the damage done to daily charts, the S&P 500 sits near the top of the global relative strength rankings.) The VIX exploded, and the media filled with portents of doom.
What caused this?
There are many possible explanations. Topping the list:
- The omicron variant of Covid poses a significant threat.
- Policy makers’ reactions to the variant (i.e., shutdowns) are a threat.
- Shutdowns in Austria, Germany, and Australia are bad signs for what’s coming.
- The Fed is going to raise rates.
- The Fed might not raise rates.
- The Fed is going to taper sooner or more aggressively than expect. Or they are not… (You are getting the point!)
- This is a normal correction in an overbought market.
- The market isn’t truly overbought, but this is still normal action within an uptrend.
- Higher levels of VIX are a good sign to buy indexes.
- Higher levels of VIX point to more stress ahead.
So, which of those is the real explanation? This is probably the wrong question to ask. Most of those things could (and likely are) true. There may also be factors not included on the list that are important, and this is a common mistake we all make—it’s easy to miss something that should be included.
It’s not so much that we are looking for the ultimate truth. Rather, there may be many things which are true, and which contribute in various degrees to the actual answer. Furthermore, the degrees to which these things are important might change over time. Not only is it a complex problem, it’s a complex problem that is always changing and even the nature of that complexity is always evolving.
Rather than thinking in black and white—in soundbite headlines—I’ve found it very useful to actively seek perspectives like this.
Incidentally, this line of thought very likely also applies to much of the politically-driven debate we are having in this country. Just to take a favorite example from the Covid confusion, consider these statements: Ivermectin has been effective in treating Covid in some parts of the world. Ivermectin is not that effective against coronavirus. Those would seem to be contradictory, but think about how they could both be true. (One explanation would be that Ivermectin has been powerfully effective in parts of the world where many infected patients also had pre-existing infections of parasites, and that this might not translate so well to other parts of the world.)
So what do we do with this? Check back soon. I’m working on another blog post that explains how a very bullish trader found himself on the short side of the market in recent weeks, and how holding these two ideas, being bullish and being short, are not necessarily the contradiction you might think.