After 20-Years Of Trading, You Learn You Know Nothing

You ever noticeā€”

That some memories tend to be stronger than others?

What sort of things do you remember?

You remember events in your life that had a lot ofĀ feelingsĀ associated with them.

You remember the death of your pet like it was yesterday. All the nights spent sitting on the couch watchingĀ Wheel Of Fortuneā€”itā€™s just a blur.

Researchers have studied this in rats. They found that rats remembered things better if they experienced a rush ofĀ adrenaline.

In those moments with strong memories, it feels like time slows down. Time doesnā€™t actually slow downā€”time is linear. But human beings experience time as flexible. Time also speeds up when things are boring.

Iā€™m fond of saying that all of finance, or at least the interesting part, is about human behavior. I find the daily fluctuations of stocks and credit spreads less interesting the older I get. And I think finance is more depraved the older I get. ButĀ the human behavior part fascinates me.

Millerā€™s Planet

The fact that time stretches and compresses isnā€™t news to anyone whoā€™s traded options.

In the world of options, time and volatility work in opposite directions. As time passes, options decay. As volatility increases, options increase in value. All stuff you learned in class.

But if you think about it, volatility increasing is another way of saying that thereā€™s a lot of sā€” going on. Things are crazy. Options increase in valueā€”which is really like saying thatĀ time is slowing down.

Which is exactly how we experience it. Of all my days trading on Wall Street, what are the times that I remember most? The financial crisis, naturally. There was a lot ofĀ adrenalineĀ associated with that.

We all have strong memories of it. And while we experienced it, it seemed like time was slowing downā€”which was reflected in options prices. They were the highest in recorded history.

Finance is simply human behavior.

If I think back over the last 10 years, what do I remember?

  • The European crisis
  • The US debt downgrade
  • The Ebola scare
  • The yuan devaluation
  • The vol-splosion

All the crazy times. Nobody remembers the stuff in between. Old-timers like me remember all the way back to 1997 and 1998, with the Asian Financial Crisis and LTCM and the Russian debt default. Itā€™s the accidents that help us mark our time in the markets.

Perspective

We all perceive things differently. As I just demonstrated, we all perceive time differently.

We also might perceive color differentlyā€”we just donā€™t know. There is no way to know that the red I see is the red you see.

We all have different perspectives, especially when it comes to financial markets. I might find a stock attractive that you find unattractive. Happens all the time.

A lot of financial analysis is searching for someĀ objective truthĀ in the markets. This is what the value people try to do. They try to identify the correct value of a security and then buy it if itā€™s underpriced.

But there really is no objective truth in financeā€”just a set of ever-changing perspectives. Some examples:

Target is up over 90%, year to date:

Is Targetā€™s business 90% better? Is it earning 90% more revenue? Of course notā€”more people find the stock attractive and fewer find it unattractive.

Pharmaceutical giant Bristol-Myers is up 48% in the last couple of months:

Again, is their business 50% better? No.

People have created several models to explain stock market behavior. Keynesā€™s beauty pageant is at the top of the list. I will always catch a beauty pageant if itā€™s on TV. The goal isnā€™t picking the most attractive contestant. Itā€™s picking the contestant that the judges will find most attractive. Itā€™s a great exercise.

But I donā€™t think thatā€™s the right model.

I came up with my own model and gave it to the world on theĀ Bloomberg OpinionĀ page.Ā You can read about it here. But I feel like itā€™s incomplete, too.

Sentiment also plays a roleā€”big turning points are always at sentiment extremes.

Iā€™m not sure what the answer isā€”or if there even is an answer. I think about it all the time.Ā  People smarter than me spend even more time thinking about it.

Maybe there is no Grand Unified Theoryā€”maybe there are regimes in the financial markets, and sometimes some things work and sometimes other things work.

Maybe the rules change all the time and there is nothing we can do about it.

I am not even sure buy-and-hold and dollar-cost averaging will work going forward.

AndĀ thatā€™sĀ what you learn when you have 20 years of experienceā€”that you actually know nothing.

That said, one thing IĀ doĀ know is that the adrenaline rush reckless traders get throwing money at ā€œhot stocksā€ is not something to aspire to. Itā€™s much better to even out your odds with a diversified, balanced portfolio and a long-term view.

 

Copyright Ā© Mauldin Economics

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