A member of my Market Timer trading service wrote to me recently to
express his frustration. Essentially, he was confused by the
multiple sources of competing research I would cite in my
commentaries. In particular, he wanted to know
why would I share
bearish research when I was so darn bullish!
Two words: confirmation bias. This is the tendency
to see and seek primarily the facts and evidence which support our
beliefs and positions. Let me give you some background on why
getting past this bias is so important to me, and why it should be
to you too.
School of the Markets
As a short-term futures trader 15 years ago, I had
to spend a great deal of time studying two areas besides charts.
Probability and behavioral finance became passionate areas of
self-education, with a little bit of brain science blended in.
Why the behavioral and brain stuff? Because as any
experienced investor-trader will tell you, we are always our own
worst enemy in the markets. Understanding how your brain actually
works from the psychologists and the neuroscientists can reap
invaluable insight and rewards when it comes to dealing with money
and risk.
Because as both groups of scientists will tell you,
the evidence is overwhelmingly in the camp that we are naturally
irrational when it comes to making solid, long-term and
short-term decisions with money and risk. (Hint: our beliefs and
emotions are almost always in the way even when we think they are
not).
What was so fascinating to me as I absorbed all
this new knowledge is that the Chicago trading pits at the CME and
CBOT were full of wile market veterans who already knew this stuff
intuitively. Or, I should say, they earned it the hard way
in the pits through lots of trial and error (losses and tears).
In 2005, I wrote a long paper titled "Your Brain
Wasn't Made to Trade" to share the best of the research from both
fields, that smart traders already knew. Part of it was published
in SFO Magazine in 2008 under the title "Mental Models of Financial
Sabotage."
Scenarios & Probabilities
To this day, I can think of no better way to check
my biases -- and my emotions -- than to read lots of competing
research -- especially from the bears when I am extra bullish. I
have a list of over a dozen institutional bears I try to keep up
with currently.
Doing so can often fortify my case, as if I can
say, "Is that all he or she is worried about?"
And it can often get me to dig further, potentially
reevaluate my stance, and consequently adjust my strategy and
positioning.
What's the danger of staying stuck in your biases?
Just ask anybody who has been short the market this year. I am not
gloating because I have been there plenty of times myself, on the
wrong side of the market and clinging to my ideas.
But if I think in terms of probabilities and always
assign a 20-25% probability to the opposite side of the Bull-Bear
coin, then I force myself to keep actively pursuing research in
that vein.
Edge/Odds
This habit actually reinforces the strength of my
current odds and analysis. Even if you are an excellent stock
researcher and picker, you know that the market and sectors can be
a big determinant of your success. So you will use the Zacks Rank
but also look at the industry and the market as a whole to put the
odds increasingly in your favor.
Since I bet primarily on indexes and sectors with
Market Timer, I must have a clear plan to know where and
when to increase or reduce my bet size. This is "probability
and risk 101" that lots of traders learned from teachers like Ed
Thorp of Beat the Dealer fame.
Thorp's 1962 book was the first to mathematically
prove that the house advantage in blackjack could be overcome by
card counting. He carried this knowledge into financial markets
with his hedge fund, Princeton-Newport Partners, which boasted a
15% annualized return over 19 years.
Thorp taught the basic relationship of "edge/odds"
to gamblers and investors, which he learned from a 1956 paper by
John Kelly of Bell Labs. Popularly known as the Kelly Criterion,
the simple idea is to divide what you think you could win (edge) by
what the horse track/poker pot/market says, or implies, you could
win (odds).
This tells you how much -- essentially, what
fraction -- of your "bankroll" to bet. Edge is similar to "margin
of safety." And though the stock market doesn't hand you guaranteed
odds, we are accustomed to assigning a risk level to every
investment or trade that almost gets us there. In the end, we have
to be comfortable with the risk, or we don't like the odds.
In a nutshell, edge/odds could be used to answer
these types of questions:
What do you "know" (or believe) that the market
doesn't know and is therefore currently undervaluing about a stock
or an index?
What stocks and sectors will benefit most from
economic trends or institutional money movement?
Where will P/E multiples go if things happen with
data, price, and news that the market is currently not factoring
in?
Built into the Kelly Criterion are the goals of
compound return and never accepting even a small risk of losing
everything. Even though it is a very aggressive betting formula, it
can obviously be diluted and customized to one's risk tolerance and
so the concept is what's really important here.
Where Will the Money Flow?
We don't have time here to get into the details of
how to apply what is primarily a betting philosophy to the stock
market, but the basic mechanics of "edge/odds" are used by many
portfolio managers to concentrate success even as they diversify
across stocks, sectors, and market correlations.
More than anything, it is a way of thinking about
risk/reward and how information of various levels of importance can
be used to adjust your exposure.
I just wanted to share the basic idea that you must
have a plan for everything from stock-picking to index/sector
allocations and their weights (bet size). And when you inform your
plan with a broad swath of information -- even the kind that
challenges your biases -- you end up with a flexible approach that
can adapt.
Instead of overreacting to market swings, you
already had that scenario in mind and knew what you would do if it
surfaced.
And where this comes in most handy is when you
catch big swings in the market that most weren't expecting, ideally
allowing you to buy and sell at great levels near turning
points.
Are we at a major turning point on this day March
8, 2012 with the Dow and the Russell 2000 yet again making new
all-time highs? I don't think so. Earlier this week I decided that
the next 40 point move from S&P 1540 would be up, not down,
with about a 65% probability, as it seems that institutions are
still underexposed to equities and, therefore, their risk is to
the upside.
So I position and bet accordingly in the rally that
still seems unbelievable to many.
As my one of my favorite poker players sums up the
key to his success, "When you get the best of it, make the most
it."
Kevin Cook is a Senior Stock Strategist with
Zacks.com
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