Category: Uncategorized

Barry Ritholtz has an interesting piece on uncertainty:

From the investor’s perspective, markets require uncertainty to function. Indeed, they thrive on doubt, imperfect information and a lack of consensus. Uncertainty drives the market’s price-discovery mechanism. Investing requires differences of opinion, for when there is broad agreement about an asset’s fair value, trading volume falls.

Without uncertainty, who would take the opposite side of your trade?

People don’t take the opposite side of your position because they are more or less certain about the future. It has nothing to do with uncertainty. It is all about differences in expectations, time frame of operation and market approach.

My take on uncertainty:

1) Uncertainty is always subjective. It is a state of mind that is derived from a mix of objective data, emotions and personal experience. To say that the market is always equally uncertain is to say that mood is always the same. It is not. It constantly changes.

If the perceived uncertainty is always the same, earnings reports would not have such huge impact on prices. We all know that this is not the case. In many cases, earnings reports provide new data that changes market expectations and therefore prices. Options premium is higher before earnings exactly because uncertainty is higher.

2) Uncertainty has become a synonym for bad mood in our everyday life.

The future is always uncertain, but our perceptions of the future vary. And perceptions define actions. Actions (supply and demand) define prices. Somehow uncertainty is used with a highly negative connotation in our everyday life. It is a game of words. Just like the weather people always say that there is a 30% chance of rain and never that there is 70% chance of sun.

3) Uncertainty is basically another word for market sentiment. High levels of perceived uncertainty (bad mood) and high levels of perceived certainty (good mood) have historically been good contrarian indicators, IF your investing horizon is long enough.

4) There are different types of uncertainty.

There is an economic uncertainty. Uncertainty leads to a decline in economic activity. Less people are hired. Old machines and software licences are used longer. Investments are cut. This is what it has been happening in Europe for 2 years.

There is market uncertainty that impacts volatility. When correlation is close to 1.0 (another way to say that stocks move together disregarding of their individual characteristics), uncertainty is perceived as high. It leads to choppy environment that market timers prefer to sit out in order to preserve monetary and mental capital. Perceptions define reality.

I’ve heard from many traders that they often take decisions based on instincts. Actually, all non-quants use intuition in some form or another. If you are not using a program that takes all signals that your system produces, how do you decide between several equally good looking trading setups with similar risk to reward? Do you take them all or do you concentrate on only a few? The odds are that you are doing the latter and your ultimate choice for capital allocation is subconscious.

Even though we are defined by our decisions, we are often completely unaware of what’s happening inside our heads during the decision-making process.

Feelings are often an accurate shortcut, a concise expression of decades’ worth of experience.

The process of thinking requires feeling, for feelings are what let us understand all the information that we can’t directly comprehend. Reason without emotion is impotent.

This is an essential aspect of decision-making. If we can’t incorporate the lessons of the past into our future decisions, then we’re destined to endlessly repeat our mistakes.

Nothing can replace personal experience:

Unless you experience the unpleasant symptoms of being wrong, your brain will never revise its models. Before your neurons can succeed, they must repeatedly fail. There are no shortcuts for this painstaking process.

This insight doesn’t apply only to fifth-graders solving puzzles; it applies to everyone. Over time, the brain’s flexible cells become the source of expertise. Although we tend to think of experts as being weighed down by information, their intelligence dependent on a vast amount of explicit knowledge, experts are actually profoundly intuitive. When an expert evaluates a situation, he doesn’t systematically compare all the available options or consciously analyze the relevant information. He doesn’t rely on elaborate spreadsheets or long lists of pros and cons. Instead, the expert naturally depends on the emotions generated by his dopamine neurons. His prediction errors have been translated into useful knowledge, which allows him to tap into a set of accurate feelings he can’t begin to explain.

The best experts embrace this intuitive style of thinking. Bill Robertie makes difficult backgammon decisions by just “looking” at the board. Thanks to his rigorous practice techniques, he’s confident that his mind has already internalized the ideal moves. Garry Kasparov, the chess grand master, obsessively studied his past matches, looking for the slightest imperfection, but when it came time to play a chess game, he said he played by instinct, “by smell, by feel.”

Our decision making depends on our expectations. Our expectations are defined by our experience, our memories in a similar situation. Intuition helps only if you have enough experience. The quantity of practice is certainly important, but the quality matters even more. The most effective way to get better at anything is to focus on your mistakes and learn from them. In other words, you need to consciously consider the errors being internalized by your dopamine neurons. This needs to become an ongoing process of constant reminding, because most of what we learn lives in our short-term memory, which by definition doesn’t last long.

WE CAN NOW begin to understand the surprising wisdom of our emotions. The activity of our dopamine neurons demonstrates that feelings aren’t simply reflections of hard-wired animal instincts. Those wild horses aren’t acting on a whim. Instead, human emotions are rooted in the predictions of highly flexible brain cells, which are constantly adjusting their connections to reflect reality. Every time you make a mistake or encounter something new, your brain cells are busy changing themselves. Our emotions are deeply empirical.

This doesn’t mean that people can coast on these cellular emotions. Dopamine neurons need to be continually trained and retrained, or else their predictive accuracy declines. Trusting one’s emotions requires constant vigilance; intelligent intuition is the result of deliberate practice. What Cervantes said about proverbs—”They are short sentences drawn from long experience”—also applies to brain cells, but only if we use them properly.

Source: Lehrer, Jonah; How We Decide – Houghton Mifflin Harcourt. Kindle Edition.