How extrapolation trips people up when trading

27/10/2014 | By | Reply More

A trend is your friend, until the end.

One of the most common mistakes I see in newbies is trend following. Trend following is when you latch on to a pattern and extrapolate it. It could be a horse that is heavily drifting or coming in, perhaps a football team on a great run or form, or a poor one. Perhaps a team has had 20 games under 2.5 goals. Is there a trend, why, or this a natural aberration?

Humans are great at finding patterns, they are tuned in to seeking them. But for all their greatness in finding patterns, it also often leads them to often make fundamentally flawed decisions. The key problem is that people tend to find patterns even if they don’t exist, then there is often an overwhelming desire to follow them. Have a read about confirmation bias to see how this often pervades a range of decisions.

One thing I’ve learnt in my career is to be contrarian, I cottoned onto the fact that the most successful people I found tended to act in this manner. But it’s one of those concepts that is simple to understand, but difficult to execute. Basically, when everybody is running in one direction you have to turn around and run against them, despite them shouting at you to run away. You have to be prepared that when you do this, everybody will think you are a fool. Buffett had a great phrase to invoke the feeling, ‘It’s like saying you married your wife because she was ugly’. During the financial crisis I acted like a fool and carefully bought distressed assets, now the economy is on the turn, these have been significantly re-rated. Now people are buying heavily, I’ll start thinning out those positions by selling into that strength.

Remember the unusual weather of last 2012? As we went through March the weather service decided that we had gone long enough without much rain to declare a drought. At that point I told some friends to start betting on a really miserable year weatherwise. My judgement wasn’t down to my meteorological ability, just one on the frailties of humans to correctly predict the future. The fact is that the weather service was extrapolating a trend. Of course as soon as the drought was declared, it just didn’t stop raining for one of the wettest summers I can ever remember.¬†Wind forward to last winter and storm after storm battered the UK. My angle, book a UK summer break while they are cheap.

All things happen within a frame of variability. When I go to bed at night I know, at least I hope, that the sun will rise in the morning. So if it’s dark then I’m happy to bet on sunshine. If it’s sunny I don’t expect that to continue forever. Markets are very similar and some of the best positions in sports markets are at exactly the point when it seems there is only one outcome. Sports markets are stuck in a closed loop, so it’s less likely that trends continue forever. But on the flip side, I’m also happy to accept that I get things wrong and will take that on chin. That’s another skill, a market equivalent of self immolation. But, unless you are really daft, it can still hurt, but doesn’t have the fatal consequences.

So, I hope that explains why I tend to act in a contrarian manner. But remember, it’s simple but not easy! If you want some guidance I’m currently reading¬†“The Little Book of Behavioral Investing” which is a good guide to some common flaws in thinking and how to overcome them. It’s a good read.

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Category: Psychology, Trading strategies

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