One of the first lessons I learned from a wise old trader was that markets move in a way that will cause people the most pain. I have sometimes found markets will cause me a lot of pain on a personal level, sometimes more pain than I can bear. However, since markets usually move with the path of least resistance, how can I reconcile the old trader's statement with efficient market theory? I never did ask him to clarify that statement, and just put it into the back of my mind. The only way he could be right is if he were referring to "people" as the general public… I don't know. Any thoughts or opinions would be greatly appreciated.

Vincent Andres replies:

"The Pareto distribution, named after the Italian economist Vilfredo Pareto, is a power law probability distribution that coincides with social, scientific, geophysical, actuarial, and many other types of observable phenomena."

– The biological world, eg jungle, is often paretian ie 10% of the jungle animals consume 90% of the jungle resources (the top of the pyramid) and 90% of the jungle animals consume 10% of the jungle resources.

– The markets are an extreme example of jungle, extreme, because since people rarely die from their failures, stupid behaviours may continue more than in a real jungle. I see the market as an extraordinary paretian machine. The normal, good working order of the machine, maintains/produces continuously a paretian distribution of the wealth among the players.

There are 90% of people who are easy to deceive and 10% of people less easy to deceive. … so the efficiency (if any), the "path of least resistance" goes exactly thru this 90/10 distribution, (and not thru an imaginary 50/50 distribution which simply doesn't exist (except maybe in some socio-communist idealized world)).

I would have rephrased your sentence as : "markets move in a way that will cause most people pain."

and this is not the fault of the "markets", the market is nothing else than the place where the people (with their 10/90 split) met. The market partition is just the people skill partition.





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3 Comments so far

  1. Bill aka NO DooDahs! on January 11, 2008 8:08 am

    Since markets aren’t efficient and the walk ain’t random, it’s foolhardy to try and reconcile anything with EMT.

  2. Matthew Chlapowski on January 12, 2008 12:41 am

    I would suggest that the pain you (and other people) feel when the market moves against your position can be mostly explained by cognitive dissonance. When you take a position, you do so based on assumptions and beliefs about the market that you expect to be rational. The belief that the markets are efficient is a premise, and from that premise logically follows a belief that by determining how the market can be quantified you can predict it’s future behavior. If the market does not do what you expect then you are faced with the psychological pain of changing your belief to conform with objective reality. The stronger the ego and need to be right, the more difficult this is to do.

    Here’s the problem: cognitive dissonance from two incompatible conflicting beliefs must be reconciled, and you can not act in accordance with both beliefs simultaneously. You must either believe one, believe the other, or believe neither. Believing both is not an option because objective evidence is telling you they can not both be true. So how does a person decide which is right? Evolution has developed an answer for that. You will naturally choose to believe the belief that reduces your anxiety the most. Police use cognitive dissonance in interrogations because it’s an effective tool for tripping up anxious people. Believing that markets are efficient and believing that out-sized returns can be made consistently are incompatible beliefs, and until one or both of those beliefs is dropped or modified you will feel anxiety from cognitive dissonance.

    People buy and sell at just the wrong times so often because they are programmed by nature to do so. It takes them time to overcome their anxiety about being wrong when they make a mistake, and by the time they do so it’s too late. I would suggest that successful market professionals make their trades when emotional levels are unsustainable, and have been so for some time. Determining when this is so (and safe to do) can be done in various ways, whether that is intuition based on experience, quantitative psychological indicators, or perhaps an advanced ability to reflect impassively on one’s emotions and take cues from them.
    Time and space, or rather emotional distance, makes it easier to make decisions objectively, which is why the markets may be generally efficient in the long term but are not particularly efficient in the short term. Human psychology determines market behavior in short time frames, and human psychology is difficult to quantify. I would suggest for this reason that mathematical market prediction is more accurate with each longer time frame (weekly is more accurate than daily, which is more accurate than hourly, etc…).

  3. Matthew Chlapowski on January 12, 2008 1:05 am

    Perhaps it would be more accurate of me to say that “at the key emotional point, more of the emotionally weaker market participants are likely to make the wrong decision compared to the emotionally stronger market participants,” rather than “by the time they do so it’s too late.”


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