Friday, November 8, 2013

Prudent Investing

If there is one piece of advice you take away from this posting I hope it's this: go play Chartgame.  It plays in your browser without any downloads and the experience will be more impactful than anything I could possibly say.

Chartgame is a simplistic game wherein you're presented with a random stock chart from the S&P 500. You must then predict whether the stock will go up (buy) or down (short) based on the stocks historical chart.  Your result is compared to a standard buy and hold strategy. Even understanding how little predictive power is inherent in historical price data I was amazed by how inaccurate my guesses were.

Chartgame illustrates a principle that many people refuse to believe. Trying to "time the market" is just dressed up guessing.  Stock charts are nice to look at but bring little actually useful information to a trader.

Recently, a study published in Neuron indicated that a highly activated dorsomedial prefrontal cortex while viewing asset activity during a bubble is significantly correlated with being tempted into investing during the inflated value period.  To quote the author of the study Camerer, "The data suggest that during financial bubbles, participants are taking into account the intention of other players in the market(or of the market as a whole) while updating their value estimates, and that this effect is mediated by the interaction between the dorsomedial prefrontal cortex and ventromedial prefrontal cortex."  Or in other words, those who are more likely to attempt to extrapolate what others are thinking are also more likely to be tempted by financial bubbles. 

The science of Camerer's work is excellent.  While his research is unlikely to make you rich, it may help keep you from losing your shirt.  Here are the important lessons to take away.  

  1. Too much information can be harmful.  Sound investment should be done on the basis of fundamental data, not on the behavior of others.
  2. If you're prone to attempting to figure out what others are thinking, be particularly cautious of financial bubbles.  
  3. Try to isolate your investment decisions from past performance of an asset. Performance can be informative in context (for example if a company began to perform poorly after a management change) but should not be the basis of a decision.  
It's interesting to note that attempting to figure out other trader's strategies is often, but not always harmful.  For example, Bruguier has shown previously that individuals who can better derive others intentions are also better at detecting insider trading and act more cautiously in markets with information asymmetries. 

Camerer's article is available for free here. Notably Camerer was recently granted a MacArthur "genius" award for his contributions to understanding financial behavior.  

That's all for this week. Until next time stay safe and rationale. 

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