JUST NINE DAYS after the most horrific attack on the U.S. since Pearl Harbor, President Bush posed a crisp challenge to the world’s 190 countries and six billion residents. “Every nation, in every region, now has a decision to make,” he said. “Either you are with us, or you are with the terrorists.”
And while the president’s point was to stress the vigilance with which the U.S. would fight the war on terrorism, the truth is that he committed a common logical fallacy that plagues even the smartest individuals, from politicians to portfolio managers.
His rhetoric was a perfect example of what logicians refer to as a “false dilemma,” or fallacy of distraction. By limiting the number of options, we forget the reality that, truth be told, there are actually more than two choices in this highly complex scenario. And whether you are coping with terrorism or Tyco (TYC), that’s usually the case.
This sort of black-or-white thinking, a topic we first touched on a few weeks back, is just one of a handful of common trading traps that can affect your performance.
When there’s money on the line and the market is moving, even the best traders have a tendency to lose their heads. Ideally, we are purely rational agents, making focused, unbiased and thoughtful decisions about when to buy or sell, hold or fold. But in practice, traders too often become emotional, myopic gunslingers who end up shooting only ourselves — usually straight in the foot. From Nick Leeson to John Rusnak, who recently lost $750 million trading currencies for Allied Irish Banks (AIB), a mind is a terrible thing to waste — and in trading, pretty darn expensive as well.
Loosely defined, a fallacy is an argument whose premises are true, but whose conclusions are false. These days, one of the most common fallacies on Wall Street is that of “inaccurate induction,” where a logical and documented argument is denied, despite powerful evidence of its validity. A current case in point: The refusal of many to acknowledge that there still exist quite a few pockets of opportunity within equities.
Sure, the major averages are soggy, but some sectors — most notably small caps — aren’t just outperforming, but kicking butt. Over the past two years, the small-cap S&P 600 is up almost 10%, outpacing the S&P 500 by almost 30% and the Nasdaq by almost 70%. But judging from what you see in the media these days, most investment advisers would rather ignore that outperformance than admit they missed it in the first place.
A similar inductive fallacy you often see these days is that of an “unrepresentative sample” — where a broad conclusion is drawn from only a narrow bit of data. An ideal example can be found within the financial sector, where consensus would suggest that stocks have, like the broad market, posted unfavorable returns. The problem is that most analysts measure the financials using the Philadelphia Banking Sector Index, or through one of the many exchange-traded funds (ETFs) that claim to follow the entire sector.
The reality, as we pointed out a few weeks back, is that both yardsticks are solely indicative of large-cap stocks, precisely the ilk that’s underperforming relative to smaller names.
In fact, among U.S. stocks, some of my biggest buys right now are among the sector’s smallest names — precisely the ones excluded from the funds and ETFs so often recommended by analysts and advisers too lazy, ignorant or scared to dig a bit deeper. First Place Financial (FPFC), First Financial Holdings (FFCH) and American Financial Holdings (AMFH) are just a few of the literally dozens of small S&Ls whose excellent performance of late most gurus simply choose to ignore.
Probably the most frequent logical fallacy most investors commit is that of “coincidental correlation,” or assuming that just because one event follows another it was caused by the first.
The most common example occurs on almost a daily basis, when both the amateurs and pros alike seek to link the Dow’s daily gyrations with whatever happens to grace the front page of the business section.
So if the market happens to be weak, the vox populi will explain away the action as being indicative of election jitters, Middle East tension, energy concerns or Enronitis. We humans have a constant human need for a logical explanation, but, truth be told, sometimes the market’s price action has none. The market moves simply because it moves. That’s what markets do.
A more specific example of this fallacy can be found within the gold sector, whose outperformance as of late most analysts are chalking up to investor jitters surrounding both 9/11 and Fastow-forged accounting fears. But as we pointed out a few months back, the sector’s strong performance actually started long before Osama bin Laden became the world’s most unappealing household name.
As simple as it might sound, the solution to avoiding most logical fallacies is to think, to reason, to look before you leap — to approach trading not as the act of making assumptions, but of debunking them. Before I put serious money on the line, I will often spend more than a few seconds examining not only my market outlook, but my thought processes as well (sometimes with the help of a little study of formal logic). Harold Hill was right: The best way to play a tune is to think it through first.
There’ve been plenty of trades on which I have lost money but those instances in which I have lost serious money, or shall we say fiscally debilitating amounts of money, haven’t arisen when I’ve been cavalier with my trades, but careless with my judgment.
It’s no coincidence that when you lose your head, you often lose your money. So before you pull the trigger on your next trade, strap the safety on your Schwab account and think critically about all possible outcomes, ramifications and results. Understand both why you’re getting into a position and what would prompt you to get out. Heed the pundits and prognosticators, and you’ll most likely just be following the herd. In my experience, when you free your mind, your assets are sure to follow.
When it comes right down to it, trading is one part observing, one part trading and one part thinking. And the ability to reason clearly and critically, especially under pressure, will boost your bottom line better than any stock pick ever could. So in the final analysis, to paraphrase Ayn Rand, when you’ve got to choose between following your heart and your head, go with your head. It’s a bet that will pay off almost every time.
– Originally on Feb 20, 2002 by Jonathan Hoenig
