Ignorance Can Be Bliss

There is an absolute limit to how much profit can be extracted from a market in any particular period of time. You will never make as much profit in the markets as hindsight and imagination can lead you to believe. Back-tested, theoretical profits will be devoured by a nearly limitless number of factors. The biggest profit eaters are shown below:Losing Your EdgeLosses from slippage, not following the plan, commissions and fees, taxes, and the relative merits of different investing styles have been covered endlessly in the financial press. But the biggest factor is largely ignored. NASAYAYA: Not As Smart As You Assume You Are. Welcome to the future! The place where everything is out of sample and all that is certain or assumed goes to die a grisly death. You think you know X. You’re certain about Y. You think 10 years of intraday data is a representative sample of something other than those 10 years. The market will react the way it “should”. You feel your past results are mostly the result of skill. Whatever it is, the more you think you know, the greater the odds that you don’t know shit. Understanding comes with a curious byproduct: The more you know, the more you know you don’t know. Thus, true insight can only come with a generous side order of humble pie.

I’ve become increasingly convinced that trading nirvana is reached when you accept your near absolute ignorance in the markets. As dangerous as the inherently uncertain future is, it’s a known unknown. The unknown unknown, and even more dangerous, is what your preconceptions are blinding you to right now.

Ben Bernanke once said he was unable to imagine a set of circumstances that would convince him he was wrong about the economy. Burdened by that level of certainty he has no real choices or flexibility left. In his world he can’t be proven wrong and if you’re right, why change?

That’s the exact opposite of where you want to be in the markets. When you accept the completeness of your ignorance you’re free to listen to the market and go with the flow. Whatever theories, beliefs, preferences and biases you have lose their power to blind you because you know they’re all crap, and any help they may provide can only be temporary.

So take a seat. It’s time to start the meeting…Hi, my name is Mortalitysucks and I’m an ignoramus.

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Next time: Knowing enough to know you don’t know much of anything isn’t the end. The next rung on the ladder of enlightenment is answering whether it’s even possible to know anything. In other words, is there really such a thing as market-beating skill? How should the answer alter your approach?

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6 thoughts on “Ignorance Can Be Bliss

  1. To me, trend following (which I often do), is the ultimate recognition that we don’t and can’t know sh!t about the market/instrument we’re trading. No matter how sophisticated your process, trend following boils down to “look, the market’s going this way, all aboard!”. It’s the anti-intellectual’s best tool, kind of zen-like. You don’t know if it’s going to reverse, and if it is, when. You just know what’s happening now. And trend following is also egoless–you’re assuming that you don’t affect the markets–why would a market reverse just because you decided to get in? You’re just riding your inner tube downstream.

    • Though I’m a born contrarian and find it very difficult to do, I wholeheartedly agree. A future post I’m working on uses trend following as one answer to the question “If you were transported 500 years into the future and forced to get into the markets, with no clue about what was going on in the markets, or even who or what the other participants were, what trading method would you use?” It’s hard to argue against it in that context, which really isn’t much different from what we deal with every day.

  2. Not true. My value model has returned 45% annualized since 2009. My results are closer to 50% after tax.

    • Not sure how your math works with those numbers, but that sort of performance isn’t rare in a roaring bull market – as the experts vs chimps throwing darts contests used to demonstrate in the 1990’s. Hopefully you’re taking the winnings off the table each year to avoid entering your first bad year with your largest position size ever. Good luck.

    • Oh, ok, really. Of all of the times to cherry pick as your starting point. Why didn’t you just say, mmm, since March 6th of 2009? If I would have just put my money into SPY in 2009…let’s say I got in at the very highest point of 2009, which would be 113. SPY is trading at 161.37 as of Friday. So, no forethought, no stock picking, no pouring over intrinsic value, no discounted future cash flows or price to book, no Fama and French. Just basically trading the stock market itself. You’d have made 42.8%. If we go with the average of 2009’s high and low values, which would be 90, your return would be 79.3%. So, not to discredit value investing or your implementation of it, but 45% is a solid but not spectacular return since the bottom of a multiyear low.

      Then there’s the little matter of 2001 and 2007. Any strategy that was tied to going long was steamrolled in the insuing couple of years. Meanwhile, trend following would have called for a mostly short strategy during this time.

      There is a large faction, mostly, I think, consisting of long horizon investors, who think that trend following isn’t…what’s the word…scholarly enough, or academically rigorous enough. Academically cool enough. No horn rimmed glasses or bow ties. I prefer to spend the majority of my brain power on risk management–especially position size and using intelligent stops that I manually trigger when market action is showing me that my premise is wrong.

      I am a daytrader of e-mini futures, so, really tough to consider value in any but the broadest ways in my arena anyway.

      And BTW, the bulk of my trades are reversion-to-mean contrarian sort of moves, but shoot, if I see a nice intraday trend I’ll definitely jump on.

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