Take a quick read of this excerpt from Business 2.0 Magazine, and see how irrational human behavior really is:
The notion that people always act rationally and in their own interest is a pillar of economic theory. So it’s interesting that a group of economists, led by the University of Chicago’s Richard Thaler, should contribute some of the most damning evidence of people’s proclivity for irrational decisions. Building on work by Princeton psychologists Daniel Kahneman and Amos Tversky, these so-called behavioral economists have shown not only that many of our economic decisions are irrational, but also that our waywardness is predictable. We get more satisfaction from avoiding a $100 loss than from making a $100 gain, for example, and we compulsively find patterns where none exist. (This stock has gone up for three days; therefore it will continue to go up.) Go ahead, point it out to us. It doesn’t matter; we’ll make the same mistakes over and over again. Thaler and others speculate that these logical lacunae are the product of a brain wired for survival on the savanna, not for hyperrational calculation. Machines do deductive and inductive calculations well. People excel at “abduction,” which is less like reason than inspired guesswork. (Deduction: All taxis are yellow; this is a taxi; therefore it is yellow. Induction: These are all taxis; these are all yellow; therefore, all taxis are probably yellow. Abduction: All taxis are yellow; this vehicle is yellow; therefore this is probably a taxi.) Abduction leaps to conclusions by connecting a known pattern (taxis are yellow) to a specific situation (this yellow vehicle must be a taxi). Compared with computers, people are lousy number crunchers but superb pattern makers — even without being aware of it. Indeed, much of what we call instinct, psychologists say, is simply pattern recognition taking place at a subconscious level.
Why does trend following work? Trend following understands people do not act rationally — and exploits that fact.
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Trading Systems Insights
“The panache of von Mises quotes is impressive, as is the batch of quotes from various other thinkers. I’m especially pleased to see some jazz luminaries up there (Mingus, Davis). As an amateur jazz bassist (former quasi-professional), I can appreciate the appropriateness of quoting jazz musicians to underscore trading principles. In jazz, one has to take chances; one has to be comfortable with uncertainty; but one also has to be prepared (knowing the tunes inside and out); and one has to execute confidently and with as much competence as possible at any moment. You can very easily paraphrase Socrates to describe how to play a jazz solo: follow the music wherever it leads. Of course, the same pattern fits trading.”
“There is one important caveat to the notion that we live in a new economy, and that is human psychology…which appears essentially immutable.”
“Fools say that they learn by experience. I prefer to profit by others’ experience.”Bismarck
Q. How can a trading approach 99% accurate not be wise?
A. If you could always pick tops and bottoms money management would not be needed. That is not possible though. Pretend a trading system was 99% accurate. The 1% failure rate could still wipe you out if you use no money management. Your 1% failure rate could be a loss that far exceeds the winners that you accumulate with the 99% accuracy ratio.
Q. Money management is complicated?
A. No. TurtleTrader is not a fan of complicated money management based on the unknown future. You can’t predict the future. Keeping things simple in terms of risk and volatility make more sense for real trading. No academic proofs needed.
Q. One of the things that disturbs me about many money management schemes is that they often neglect protecting open profits. For example they might assume that we should only risk 1% of our equity on a new trade but they will risk 15% or more of the equity from an open position profit down to where the exit stop is. The justification is that they are trying to maximize their profits by going for the big winners. I see many traders giving back bigger profits than they are catching. I think this is a big mistake. I like to protect open profits more than most traders. Just seems logical to me.
A. Why is this logical to you? If you are so concerned about protecting every dollar you happen to make, you will lose. You must be willing to risk new profits to get larger gains. Your thinking is very similar to the guy that thinks he is playing it safe by investing 100% in bonds. Reality shows to not take risk is actually riskier. Think about it.
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