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February 13, 2005
Trading: Don't be Married to your Position
People who constantly change their minds are often thought of as flighty, inconsistent, even unreliable.
Nassim Nicholas Taleb, in a recent article published in The Daily Reckoning, wants to prove that theory wrong and show that those who start each day with a clean slate and new ideas make the most rational investors.
He claims that in today’s world, self-contradiction is considered culturally to be shameful, and goes on to quote from Proust, whose novel A la Recherche du Temps Perdu ("In Search of Lost Time") features a semi-retired diplomat, the Marquis de Norpois, who, like all diplomats before the advent of the fax machine, was a socialite who spent considerable time in salons. The narrator of the novel sees the Marquis openly contradicting himself on some issue (a pre-war rapprochement between France and Germany). But when reminded of his previous position, he did not seem to recall it. Proust reviles him:
"Monsieur de Norpois was not lying. He had just forgotten. One forgets rather quickly what one has not thought about with depth, what has been dictated to you by imitation, by the passions surrounding you. These change, and with them so do your memories. Even more than diplomats, politicians do not remember opinions they had at some point in their lives and their fibbings are more attributable to an excess of ambition than a lack of memory."
The Marquis is made to be ashamed of the fact that he expressed a different opinion. Proust did not consider that the diplomat might have changed his mind. We are supposed to be faithful to our opinions or be considered a traitor!
It should be mentioned at this point that Taleb is a trader and professor of mathematics, specializing in the risks of unpredicted rare events ("black swans"), who has held senior trading positions in New York and London, before founding Empirica, a trading firm and risk research laboratory.
And Taleb believes that the Marquis would also have made a good trader. However, he considers that the public person most visibly endowed with such a trait to be George Soros, one of whose strengths being the facility to revise his opinion rapidly, without the slightest embarrassment. He goes on to provide an anecdote perfectly illustrating Soros' ability to reverse his opinion in a flash:
The French playboy trader Jean-Manuel Rozan discusses the following episode in his autobiography (disguised as a novel in order to avoid legal bills). The protagonist (Rozan) used to play tennis in the Hamptons on Long Island with Georgi Saulos, an "older man with a funny accent," and sometimes engage in discussions about the market, not initially knowing how important and influential Saulos truly was. One weekend, Saulos exhibited in his discussion a large amount of bearishness, with a complicated series of arguments that the narrator could not follow. He was obviously short the market. A few days later, the market rallied violently, making record highs. The protagonist worried about Saulos, and asked him at their subsequent tennis encounter if he was hurt. "We made a killing," Saulos said. "I changed my mind. We covered and went very long."
What characterizes real speculators like Soros, differentiating them from the rest is that their activities are devoid of path-dependence. They are totally free from their past actions. Every day is a clean slate. Quoting from Taleb:
"There is a simple test to define path-dependence of beliefs (economists have a manifestation of it called the endowment effect). Say you own a painting you bought for $20,000, and owing to rosy conditions in the art market, it is now worth $40,000. If you owned no painting, would you still acquire it at the current price? If you would not, then you are said to be married to your position. There is no rational reason to keep a painting you would not buy at its current market rate – it is an emotional investment. Many people get married to their ideas all the way to the grave. Beliefs are said to be path-dependent if the sequence of ideas is such that the first one dominates.
There are reasons to believe that, for evolutionary purposes, we may be programmed to build a loyalty to ideas in which we have invested time. Think about the consequences of being a good trader outside of the market activity, and deciding every morning at 8 a.m. whether to keep the spouse or part with him or her for a better emotional investment elsewhere. Or think of a politician who is so rational that, during a campaign, he changes his mind on a given matter because of fresh evidence and abruptly switches political parties. That would make rational investors who evaluate trades in a proper way a genetic oddity - perhaps a rare mutation. Researchers found that purely rational behavior on the part of humans can come from a defect in the amygdala that blocks the emotions of attachment, meaning that the subject is, literally, a psychopath. Could Soros have a genetic flaw that makes him rational as a decision maker?
Such trait of absence of marriage to ideas is indeed rare among humans. Just as we do with children, we support those in whom we have a heavy investment of food and time until they are able to propagate our genes, so we do with ideas. An academic who became famous for espousing an opinion is not going to voice anything that can possibly devalue his own past work and kill years of investment. People who switch parties become traitors, renegades, or, worst of all, apostates - those who abandoned their religion were punishable by death."
You can read the full article here: Spotless Minds
Taleb's interests lie at the intersection of philosophy, mathematics, finance, literature and cognitive science, but he has stayed extremely close to the ground, thanks to an uninterrupted two-decade career as a mathematical trader.
His book Fooled by Randomness, into its second edition in 2004, has been published in 14 languages, and the author's ideas on sceptical empiricism have been covered by hundreds of articles around the world. In it he examines what randomness means in business and in life and why human beings are so prone to mistake dumb luck for consummate skill.
Posted by Tony at February 13, 2005 07:52 PM
Comments
Nassim Nicholas Taleb is indeed a thought provoking fellow.
For me, the interesting questions about marriage to ones ideas , is why?
Why are most people married to most of their ideas, and why are there some who are have an easy ability to to achieve a quick divorce; to turn around and go the other way, and seemingly feel perfectly comfortable with that. This raises a corollary query, simply put, how does it feel to be able to do this? I place this corollary question on the basis of truism that human beings don't usually do what they don't want to do
If we Homo Sapiens (which in the world of investment seems an oxymoron) are generally fixed in our belief sytems, with tightly tied marital belief knots, what is the overall advantage? What is the advantage of genrally not changing one's mind and what might be the group advantage, and indeed, the personal advantage for the person who does do this. I'm thinking here in evolutionary psychology terms.
This raises the notion of risk taking. The overly well cemented marriage to ideas can lead to lack of change. Innovation and creativity is bound up with risk taking.
Risk taking behaviour has to be rewarded, not only by the outcome of the risks taken, but by the act of simply taking the risk.
And this leads me full circle here: how does it feel?
I suspect that those, like Soros, who can reverse a decision and turn around and go the opposite way, are the risk takers par excellence. If the change of mind does not correlate with any new content of mind, then it is the very act of changing of mind in itself which impells this. But how does it feel to be Soros (with some $25 billion, it no doubt feels good) when he achieves what others seemingly cannot. My hunch is that he gets a buzz from it. This sort of reversal of intention must be pleasurable in some way.
Until recently, the study of risk-taking behaviour, what some have called "motivated irrationality' has been a rather orphaned subject. However a recent conference on "Self-Regulation and Risk-Taking Behavior,' sponsored by the National Institute of Mental Health (NIMH) in Bethesda, USA, brought together psychologists, psychiatrists sociologists and neuro-scientists to pool their understanding of the more venturesome among us. They examined the spectrum of perilous behaviour, and came to the conclusion that some degree of fearlessness is admirable, especailly to potential mates. Of the possible explanations for such diverse behaviours, which, on the face of it, appears almost counter-evolutionary, the biochemical rationale is perhaps the most controversial.
There is, however, a lot of evidence that some people are biologically predisposed "sensation seekers,' with a preference for novelty, complexity and intensity of experience. There was a correlation between the ease of changing one's mind with the need to seek new sensations.
Compared to the population as a whole, sensation-seekers tend to have lower levels of brain monoamine oxidase, an enzyme which breaks down certain neurotransmitters related to emotion and cognition. Sensation-seekers also tend to have lower levels of DBH, a brain chemical that, when low, has been associated with manic states. In addition, they have higher levels of gonadal hormones which is known to play a role in aggressive behaviour.
A significant genetic correlation has been found for the trait of sensation-seeking. We inherit different enzymes which regulate our nervous systems. High sensation-seeking is probably not due to high levels of neurotransmitters, but to a lack of certain regulatory controls.
Other animals have been shown to take risks for social reasons; the underlying theory being that by taking risks, a less able animal would have to avoid, they demonstrate the superiority of their genes and become more attractive as a mate. Interestingly some studies have found this phenomenon in humans too, with people who engage in high risk sports seen to be more sexually attractive. Add to this to the apparent fact that females find wealth in itself to be encouraging of sexual contact and we might know why short, fat, ugly, enormously rich men who regularly change their minds about business deals have such attractive , tall, willowy blonde wives.
Excuse the rambling, but it's 2.15am in the morning!
B
Posted by: B at February 23, 2005 02:11 PM