Ivanhoff Capital

It is said that the four most dangerous words in the financial markets are “This time is different”. History rarely repeats, but it often rhymes. The truth to the matter is that it is always different and it is never different. The hot investing themes and stocks change every few years, but the investors psychology and the price charts of the best performers always look the same.

Recently I stumbled upon a paper titled “Predicting the Improbable“. The line that made me the biggest impression as I was able to relate it to the stock market goes as follows:

People tend to adjust their expectations of future events based on only small pockets of recent experience. In lotteries they tend to under-select recently drawn numbers, only to get for them in a big way if the number is drawn repeatedly.

This is essentially how trend following works. At the beginning of a new trend, there is usually an abnormal range and volume expansion. At this stage most market participants are reluctant to buy because the stock looks extended. The sudden change of the supply/demand dynamics often causes a “freeze” reaction = doing nothing. No one is willing to chase at this point, despite the fact that breakouts of long bases often precede much higher prices over time. The expectation of mean reversion is natural as it would restore the “balance”. Most traders are waiting for some form of consolidation for two reasons:

1) clear level to place a stop
2) prove of institutional support

The first major breakout is always considered an outlier and most market participants intuitively will desire to short it or simply will stay on the sidelines. At the beginning of a new major trend, people tend to under-react. As the breakout is followed by higher prices and more breakouts, more and more people become believers in the validity of the new trend and gradually the fear of missing out become stronger than the fear of losing. That fear of missing out has a particular name. It is called greed among independent investors and career risk among institutional managers. This is the time when the market start to proactively discount and the dreams of future potential trump the reality.

What happens when a stock doesn’t form a base after a 20% breakout, but continues to rise? The more a stock extends above its base and major moving averages, the less natural it looks to the human eye. It seems counter-intuitive that the move can keep going. For those who already own the stock, psychologically it feels harder and harder to stay and continue to ride the trend. For those on the sidelines, shorting becomes more and more enticing. This is the time, when the perspective becomes increasingly important. If you look at a monthly chart of the best performing stocks for the past year or for any other year, you are likely to notice nice green candles, one after another. At the monthly chart, most of the great performers will constantly look extended from their base. The more you decrease your horizon and move into weekly, daily and hourly charts, the more evidence of consolidation you will find and therefore places to put your stop.

Very few are able to ride the majority of a trend. The common scenario is that there are different owners at the different stages of a trend and what is buy signal for one might be a sell signal for another.

There are about 7 billion people currently living on the Earth. Each and every single one of us has a different perspective regarding anyone and anything. Do you know why? Because everyone has slightly different past experiences and the way we see the world is determined by our memories. Without them, we don’t have a basis to compare to and without a basis to compare, we are lost. We don’t know how to feel. We perceive through association. We associate based on something already experienced.

I distinguish two types of intuition – inherent and acquired. Inherent is the one you were born with and it is the end product of hundreds of thousands of years of evolution aka trying to survive in the fields. We are wired to seek instant gratification without a deeper thought about the future consequences, we are loss averse and stubborn.

While the inherent (core) intuition is the pre-installed software, each and everyone of us is born with, the acquired intuition is the upgrade we get through life as it is based on everything we experienced. Your brain remembers everything, even if you don’t realize it. Of course you can easily recall only the most vivid memories as depending on your everyday activity the brain has prioritized what is important and what is not.

When it comes to trading or investing, there is a reason you like some patterns more than others. The question is, should you trust your intuition? The contrarian school of thought in the market teaches that you should try to fade your intuition as it usually points you in the wrong direction. This is not always the case. If you have enough experience, your intuition is your biggest edge as it recognizes combinations of patterns and factors invisible for the normal eye.

Which has stronger influence on your decision making – your hereditary intuition or your acquired intuition? For fields you don’t have enough experience with, you hereditary intuition is likely to prevail and in the many cases it will urge you to take not the most efficient step.

All of us are naturally wired to think in terms of mean reversion. This is how the nature works – everything is balanced, everything is cyclical. We tend to project the linear relationships from the physical world unto the non-linear financial world. I have had my fair share of wrong moves in the capital markets and over time I realized that mean reversion does not work for me. My experiences conditioned me to see danger or more precisely – better alternatives, where other people see opportunity. Don’t get me wrong. I am not saying that mean reversion way of thinking is wrong. There is an exorbitant number of living examples of people that have figured out how to be immensely profitable using it. I have accepted that it is not for me and decided to specilize in trend following. You just have to find what works for you. Most people find that the hard way.

Mozart has long been considered a musical genius that is born once in a 100 years. His amazing talent was recognized when he was still 5 years old. Today, there are hundreds of 3-4 year old kids that are 10 times better than the 5-year old Mozart. Today we know much more about the creation of geniuses and how to leverage that knowledge. This is why I am an optimist about the future.

Robert Fischer became a grand master before he turned 16. He was considered a chess legend at the age of 13. Today, there are hundreds of 10-11 year old kids that would kick the ass of the 13 year old Fischer. We  know much more about how to learn efficiently and how to achieve expertise in any area of life. The existence of computer simulations significantly accelerates the creation of chess geniuses.

Today we know that the grand chess players don’t really think, they react. They derive their next move from their long-term memory, which has archived millions of combinations as opposed to lesser developed players, who have to apply conscious mental effort to take a decision. The best chess players think like computers. I would argue the same for the best traders, even if some of them don’t realize it. The trading wars will be won by computers, but there will always be enough fish for the skilled fisherman.

Social media can do for traders what simulated computer programs do for wanna-be chess masters. In the 1990s, Jack Swager said that he had troubles finding true investment superstars for his Market Wizards books. Social media did not exist then. Social media is important not only in terms of its discovery function, but also in terms of faster development of talent. It accelerated the learning curve and it produced hundreds of new great traders. This process has only just begun.

Social media overcomes the geographic limits of time and space and the psychological and cultural limits of perceived status, and opens a whole new world of collaboration. Some people say that social media is noise for the real traders, who have to rely only on themselves to be successful, but as with all tools – something can be very dangerous in one’s hands and extremetly useful in another’s. You just have to learn how to use it.