IN LAST month’s issue of Bloomberg Markets, Denise Shull, president and founder of Trader Psyches Inc, a New York–based consultancy which employs neuroscience and psychology to help traders, reminds us that investing is all about one basic question: “Down the road — in five seconds, five months or five years — will someone else pay a different price for an asset than you will now?”
As she goes on to say: “Whether you use fundamental research to try to discover undervalued companies, technical analysis to identify entry and exit points … or quantitative modelling to find probabilistic relationships among prices ... it all boils down to the same thing.
“Everyone forgets that it’s fundamentally a question of predicting other people’s behaviour.”
She expounds on the theme in this year’s Spring issue of the CME Group magazine.
“Regardless of their substantial differences, both the market technician and the fundamental analyst attempt to predict future asset prices via the lens of mathematics and probability,” Schull writes in a guest column.
“Yet the more basic question, the one the numbers try to reflect, the price that another human being will be willing to pay in future, may be better asked directly. The study of risk-decisions from the perspective of brain processes promises rewards. Recent experimental evidence points to the ability to predict another person’s behaviour as more helpful in reading markets than pure probabilistic thinking. Think of any market player. Their perceptions are not about the bars, lines and formulas, but about the people behind the flashing electrons.”
What stops us writing a winning algorithm, says Schull is our perceptional abilities in ambiguous situations — or what the decision scientists define as “uncertain outcomes with uncertain probabilities”.
She agrees with Frank H Knight who in 1921 claimed markets are always ambiguous and what we call risk or uncertain outcomes with known probabilities is but an illusion. “Predicting future prices is not like the algebra we did in ninth grade,” says Schull.
“The market is not hiding a set of absolute numbers with immutable relationships where the answer emerges from solving for the missing factor.
“Yet ... humans consistently prefer known, quantifiable risks to ambiguity. This explains our affection for the quantitative ... but we are simultaneously quite adept at making judgments in uncertain circumstances. In other words, our innate ability to interpret ambiguity gives us information that numbers alone will never find. Brain imaging (pictures of brains making decisions) indicates that we perform different mental gymnastics when we realize we lack all the factors. We seem to use the context to fill in the blanks when we consciously or unconsciously sense that the equation cannot be solved for X.”
Does that mean we should abandon efforts to work off projected probabilities? “Of course not,” says Schull. Projected probabilities offer a valuable tool, but we should admit that they are insufficient.”
MICHEL PIREU: pireum@bdfm.co.za