Kahneman and Markets

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  • on June 2nd, 2012

Daniel Kahneman is the godfather of Behavioral Finance. He recently gave a speech at the CFA Conference highlighting the many pitfalls humans face in our decision making. Having read much of his work over the years, as well as his wonderful book Thinking, Fast and Slow, I found little new in the speech but would never miss a chance to hear him talk. Kahneman is a revolutionary thinker and his work is at the heart of everything we read about how our brains process information.

A trader he is not. Asked by the moderator what we can do to overcome our well-known biases against successful investing and his answer was “Not much.” On this, I call BS…there is a ton we can do. Agreed, as a whole there is no way most in that room are going to make the effort to use their behavioral strengths and overcome their weaknesses; if everyone did, there would be no chance to gain an edge in the markets. But the fact that some will fail to both accept our flaws AND implement change to overcome them means that those who do gain that edge from those who don’t. This is natural selection, market style.

Kahneman wonderfully separates our processing into System 1(natural) and System 2(analytic); he admits that it’s not quite that simple, but in another sneaky behavioral lesson teaches us that we’re more likely to learn these concepts if the images are starkly divided into two different “actors”. Again, he teaches something about teaching while teaching…love the guy for this.

Anyway, the constant information flow of markets makes System 2 necessary; without deliberate preparation most of us would lose touch with our compass and cave in to impulse. But it’s the intuition of System 1 that allows us to make quick decisions without all the facts, and any experienced participant knows we can never have all the facts.  I’ll share an example of one part of my process that was a) learned over the years in System 1, b) standardized in System 2, and c) cleanly converted back to System 1 for my daily use. Take a look at the following graphic:

 

 

What is it? It’s a robust(tracks 400 liquid stocks), dynamic(changes as evidence changes), objective(price-based) set of broad market calculations that spits out a piece of information that I can interpret in 2 seconds. It’s not tied to a piece of economic data or spike in $ES_F caused by some weird trading algorithm. It represents the collective actions of everyone operating in the trading of the largest U.S. corporations across all operating sectors(I exclude utilities and REITs because of their quirks). Unlike the standard chart view that has me caught between emphasizing level or direction, this calculation includes both so it takes another step out of my decision-making process.

It’s not perfect, but it’s perfect for me. I have a blueprint for each “scoring region”, and know exactly what it takes for me to change course. It doesn’t tell me what the market did in the last 5 minutes, or what it will do in the next 5 years. But its characterization of risk appetite guides me to what I will do, and there is not any impulse that can knock me from focusing on my planned set of scenarios. Trust me, I haven’t figured out a way to get rid of the impulses, but their rank on my attention scale lessens by the year. For better or worse, trying to make money on $FB never entered my mind in May. I know my skill set, and gave up trading IPOs long ago.

I’ll continue reading everything Kahneman writes, partly for pleasure but also because he gives us ways to think about how we think. But for prescriptive tactics on working with our natural wiring, I lean on trader/psychologists with real world experience…Steenbarger, Shull, Pearlman, Tharp, Miller, & Menaker are a great place to start. Traders and investors who’ve committed ungodly hours to System 2 planning make up the vast majority of my Twitter stream; those who show rare System 1 abilities make up the rest. Both groups inspire me to improve, and offer me a constant look at how a market participant successfully works in harmony with their emotions but against bias. The fact that even one big fund manager won’t commit to finding ways to break through his biases means there will always be opportunities for those who will.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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