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the psychology of successful trading

The Illusory Truth Effect And Financial Markets

Introduction

The Illusory Truth Effect is a variant of how we inaccurately use our feelings to make decisions.  We use at least two methods to decide on the truth of a claim or the correctness of new information.  The first method is somewhat allied to one of the philosophical account of knowledge: coherentism.  We assess the claim based on whether it is consistent with what we think we already know.  The second method is to consider how we feel about the claim or purported new information.

Drawbacks of the Illusory Truth Effect

Both approaches have drawbacks.  The first method, while probably the best available, can lead people into multiple errors.  If you already believe something false, you are more likely to believe further false claims. This is especially true if the new false claims are linked to the first false claim.  We see many pernicious illustrations of this; for example, in political polarisation and various forms of prejudice.

The second approach is more damaging.  In fact, deciding whether something is true or not based on how we feel about it looks so odd that you might wonder whether it can possibly be the case that this happens.  This is another example of a puzzling psychological bias which in fact it makes sense for us to exhibit because, on average, it will produce an answer which is “good enough.”

We Dislike Work

One thing we don’t like is work.  If we have seen a claim a lot before, we don’t need to work too hard to decide whether it is true again.  (This is also a processing fluency effect.) We are comfortable with the claim or the apparent information.  I don’t need to think about the route to walk to the gym because I have done it a lot before and it always worked.  This familiarity effect or ease of processing effect is fine in relation to the route to the gym.  And there are going to be a lot of daily questions like that where it would be inefficient to reevaluate them.

This is all fine.  However, it turns out that we also do this with false claims which we have seen often.  That of course is going to be a huge problem.  The Illusory Truth Effect is also known as the Reiteration Effect for this reason.  Basically, if I tell you something which is false a lot of times, you are likely to get comfortable with it and more likely to believe it.

The Illusory Truth effect and the Bitcoin Bubble

This will have frequent damaging effects in financial markets.  For example, in the case of the Bitcoin bubble, which I forecast approximately three days before the peak. See https://en.wikipedia.org/wiki/History_of_bitcoin for some history.

There are I think some causal factors deriving from the Illusory Truth Effect, though as I discuss there, there are many other psychological biases and errors at work in the bitcoin bubble.

Photo by David McBee on Pexels.com

In particular, what we saw in the case of the Bitcoin bubble was the cult-like nature of the phenomenon.  Proponents of the cryptocurrency repeated hundred of times the same false claims. For example: “it can only go up;” or “Bill Gates is enthusiastic about it. ” Finally: “all we have to do is HODL (sic) and everything will be fine.”  Cult members believed all of this partly because they had heard it all many times and so they became familiar with it.

Other Symptoms of the Illusory Truth Effect

Turning to the professional sphere, we can expect that the Illusory Truth Effect will play a part in any bubble involving more than just the inexperienced investors who became infected in the Bitcoin epidemic.   DotCom caught a lot of people (including myself, because I was young and inexperienced.). We heard many times that anything involving the internet was going to be a huge success.  So we started to believe it.

There are many features of markets that are true until they aren’t.  Try to avoid believing something merely because you have heard it a lot.  Look for evidence.

See Also:

The Late Evaluation Effect And Financial Markets

Categories
the psychology of successful trading

Better Traders Like Bitter Tastes

Introduction

Evidence shows that there are correlations between liking certain bitter tastes and certain personality factors.  This means we can construct an argument to show that better traders like bitter tastes, because we also know that personality factors correlate with taste preferences.

Personality as generally understood does not really exist; the belief to the contrary is known as the Fundamental Attribution Error.  However, there are some stabilities in character which are or approach being diagnosable as “personality disorders.”  These though are very much in the eye of the beholder in terms of whether or not they impair effectiveness.  It turns out that these same personality stabilities are highly prevalent in competitive professions, so these people must be doing something right.

Data to Show Better Traders Like Bitter Tastes

Researchers found that:

Individual differences in bitter taste preferences are associated with antisocial personality traits

University of Innsbruck
Photo by Pixabay on Pexels.com

Bitter tastes are basically self-explanatory.  Marmite and gin and tonic are two obvious examples, but tea or coffee without sugar could be others.  One could also look at wine types.

The authors found robust correlations between preferences for such bitter tastes and the Dark Tetrad, which is the Dark Triad plus everyday sadism.  The Dark Triad is one of the stable factors in personality.  It consists of Machiavellianism, psychoticism/psychopathy, and narcissism, at levels below threshold for diagnosis as a personality disorder.

University of Innsbruck

Machiavellianism

Machiavellianism could also be termed manipulativeness.  It reflects how likely someone is to be devious or to manipulate others for their own benefit.  Psychosis means susceptibility to delusions.  Some false beliefs — especially false positive beliefs about the self — are correlated with individual success.

Psychopathic Tendences

Some authors in the literature include psychopathic tendencies instead of psychosis.  These tendencies come from a wide potential array of behaviours.  Some or all of the following may be present:

  • glibness
  • superficial charm
  • grandiosity
  • pathological lying
  • manipulation of others
  • lack of remorse and/or guilt
  • shallow affect
  • lack of empathy
  • failure to accept responsibility
  • stimulation-seeking behaviour
  • impulsivity
  • irresponsibility
  • parasitic orientation
  • lack of realistic life goals
  • poor behavioral controls
  • early childhood behaviour problems
  • criminal activity

Obviously some of these are very unhelpful.  But we can imagine that others could be extremely useful.

Narcissism

Narcissism is an extreme level of self-absorption and self-belief.  This looks as though it will be really quite useful in terms of allowing people to fail repeatedly with no adverse ego consequences. One well-known example is Donald Trump. He has been in some ways very successful despite frequently and comprehensively failing. His political career has been as negative and damaging as his business career, but he doesn’t care. He may not even know.

We know that the Dark Triad –and presumably also the Dark Tetrad, since that is very similar — are heavily over-represented in certain professions.  That is: investment banking, journalism and politics.  All of these professions are extremely competitive and perhaps also require a certain amount of ability to exploit others.  This can therefore explain why the Dark Triad would often be seen on the trading floor as well.

Conclusions: Better Traders Like Bitter Tastes!

Of course, this shows correlation rather than causation.  However, since we have a plausible explanation as well as a correlation — it seems likely that being a Dark Triad person will be valuable when trading.  And now, since we have observed correlations* with bitter taste preferences, there is an easy way to check!

(Disclosure: I am well-known for liking ridiculous amounts of Marmite.  I don’t mind a gin and tonic either.  And I wrote this: https://www.amazon.co.uk/Psychology-Successful-Trading-Behavioural-Profitability/dp/1138096288/

(So that’s one more data point!)

See Also:

What Is “Theory Of Mind?”

The Illusory Truth Effect And Financial Markets

The Late Evaluation Effect And Financial Markets

The #Bitcoin Bubble Is Caused By The Halo Effect

Categories
the psychology of successful trading Trading trading psychology

The Halo Effect is One Cause of the Bitcoin Bubble

What is the Halo Effect?

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The Halo Effect occurs when people judge the overall quality of an item or person by considering only a single property of that item.  This can lead to dramatic errors; most obviously when all of the other qualities of the item  are negative or highly questionable.  This I will argue here is one causal factor among several which have caused novice investors to buy Bitcoin.  When it crashes, they will lose all of their money.  They will be unable to exit the market because the power of the cognitive bias is too strong.

In this post, I will briefly set out the cognitive biases which are in play here before describing the Halo Effect and how it is another feature of human psychology which leads people to mistakenly buy Bitcoin.

Why People Like Bitcoin

The Halo Effect is not the only causal factor operative among the novice investors who are buying Bitcoin.  I have already argued elsewhere that another causal element is that Bitcoin buyers prefer their own experiences to any consideration of statistical data. In addition, Bitcoin buyers share with Trump voters a distrust of experts, as I have also argued elsewhere.

We can see that as a two variants of the Dunning Kruger effect.  Here, people who lack competence are unable to detect such lack of competence. This makes intuitive sense since people who lack competence and are aware of it would presumably either take steps to address that lack or avoid activity requiring the relevant competence.

https://www.psychologytoday.com/gb/basics/dunning-kruger-effect

A corollary of that is seen in another variant of the Dunning Kruger effect. People who lack expertise are unable to detect true expertise.  We can see this when someone is able to publish a book on Bitcoin when it is quite apparent that they do not have even a basic understanding of it.  For readers of this book, it must be impossible to recognise and benefit from well sourced, properly constructed arguments, for example in the mainstream media.

Origins of the Halo Effect

The Halo Effect was first seen in data about personality assessment in the military.  Officers asked to rate their subordinates would in fact rely on a single criterion. They would then assume that all other relevant factors were correlated with that one criterion.  This is obviously dramatically false unless all of the other variables are correlated with the one assessed.  And that is highly unlikely to be true.

False Claims About Bitcoin

Many people are unable to distinguish Bitcoin from the blockchain.  This leads many of the novice investors who are buying Bitcoin to fail to distinguish between the two claims “I am buying Bitcoin” and “I am investing in blockchain technology.”

The blockchain is a distributed ledger system which offers transparent recording of transactions (or any data) without the backing of any central authority.  It is an extremely interesting technology which holds great promise.  It could create corruption-resistant property ledgers.  That would be of great benefit, not least in combatting money laundering.

Bitcoin is termed a “cryptocurrency” even though it does not fulfil the roles of a currency in that it is not readily convertible and it is not a stable store of value.  It rewards the miners who maintain the blockchain on a widely dispersed set of servers.  However, it is clear that the blockchain and Bitcoin are not identical.

So this is how the Halo Effect kills traders. They confuse a potential positive quality with all properties. Bitcoin uses the Blockchain. The Blockchain is interesting. Therefore Bitcoin is interesting as an investment. This does not work even if it is true that the Blockchain is interesting. And even that claim is highly questionable.

A Potential Response From Bitcoin Proponents

An objection has been attempted here by a Bitcoin proponent that it is not possible to have a blockchain without a cryptocurrency.  There are a number of readings of that, but on the obvious two, the claim is either false, or true but misleading.  If the claim means “you cannot run blockchain code without also generating a cryptocurrency” then it is false. Blockchain code could run with the cryptocurrency elements redacted. Or they could have zero value, which achieves the same thing.

If the claim means “it is necessary to compensate the miners, ” then it is true.   However, the miners could get $.  Or the blockchain could run in the cloud, or in many clouds.  That would carry some costs, but this is not a problem.  It would even be possible to compensate the miners in a cryptocurrency which was pegged against the $.  There is no need for the cryptocurrency to appreciate and definitely not to gyrate wildly.  I therefore conclude that the objection fails.

Why All This Means Bitcoin is Toast

There is one positive property that Bitcoin possesses.  It is true that it is generated using the blockchain technology.  It is also true that the blockchain technology is extremely interesting, and being pursued widely by a number of serious players.  By contrast, no professional, experienced or institutional investor is holding Bitcoin.  Novice investors fall prey to the Halo Effect when they think that the one positive quality of Bitcoin is a measure of its overall quality, when in fact it has no other redeeming features at all.  This will prove to be a very expensive cognitive bias when the Bitcoin crash comes.

See Also:

The Forthcoming #Bitcoin Crash Will Kill The #Trump Demographic

The #Anecdotal Fallacy And The #Bitcoin Bubble

Bad Arguments for the Permanence of Bitcoin

Categories
the psychology of successful trading

The “Wisdom of Crowds:” Very Risky in Financial Markets

Introduction

The “wisdom of crowds” is the idea that people are generally right so we should generally do what they do. Unfortunately, while they are generally right, they are usually wrong in financial markets. So there is no wisdom of crowds to be found there. That doesn’t stop people relying on it. Here I will suggest you should go your own way. It will be very expensive to follow the crowd.

We all tend to do what everyone else does, even when we can see that everyone else is wrong.  In financial markets, this can lead to bubbles and herd behaviour.  It is important to be aware of this tendency within our psychology, so you can at appropriate times avoid joining in the bubbles.  It is important to do this because you will lose a lot of money if you participate or, once in, fail to exit before everyone else does.

In this post, I will briefly outline the relevant psychology. So you can both look for the effects in your own thinking and expect those same effects in other market participants.  This will improve your trading.  I discuss this bias and many others in a financial markets context in my new book The Psychology of Successful Trading.

Photo by Mike Chai on Pexels.com

Conformity Bias

Conformity Bias is also known in the literature as the Asch Effect, after the pioneer experimenter.  Asch obtained really surprising results, which will show you how strong this effect is.  He had a naive member of the public sit in a room in front of a blackboard with four other people.  The member of the public thought that the other four people were also naive members of the public. In reality they were actors who were going to behave in a specific way suggested by Asch.

https://www.simplypsychology.org/asch-conformity.html

The experimenter draws a line of a certain length on the left side blackboard.  The experimenter also draws other reference lines of different lengths on the right hand side.  One of them was clearly the same length as the reference line. All of the rest were clearly much shorter or much longer.  Asch then had the people say which of the test lines on the right was the same length as the reference line.

If the naive member of the public went last and heard all of the actors give a wrong answer, he tended to go along with them. That was true even though the answer was obviously and clearly wrong.  Amazingly, Asch found that most people gave an obviously wrong answer some of the time. Some people gave wrong answers most of the time.

This is how strong Conformity Bias is: it works even when the answer is obvious.  Imagine how much more dangerous it is in financial markets. The answers are much less clear cut and much ambiguous and conflicting data must be weighed.

Bubbles are Caused by the Wisdom of Crowds

I think this is one factor behind a lot of famous bubbles in financial history. Right now, it looks to me as though the cryptocurrencies, most notably Bitcoin, are exhibiting bubble characteristics.  One sign of this is the enthusiasm of a particular football manager, one noted for his lack of financial acumen, for Ethereum.  I do not say this is a scam; I merely suggest that one should look to more fundamental underpinnings for value than “everyone likes it and it has gone up a lot.”

Avoid Conformity Bias and trade better by trading the other way when you see it happening.

The wisdom of crowds might get you across the road but it will kill you in trading.

See Also:

What Is “Theory Of Mind?”

The Illusory Truth Effect And Financial Markets

If You Like Gin And Marmite, You Are Probably A Better Trader

The Late Evaluation Effect And Financial Markets