Thursday, May 11, 2006

Isaac Newton, Rats, and Stock Trading

Isaac Newton, one of the inventors of modern Calculus and arguably the discoverer of a great deal of what we know about physics and mechanics, one spent a gruesome afternoon sticking a rod into his eye socket to deform his own eyeball. The purpose of his remarkably dangerous experiments was to get some idea of how prone to error the human eye might be in various circumstances. Newton had come to realize that our perceptions of the world are subject to errors due to the machinery in our own heads just as easily as errors in a telescope or other piece of lab apparatus. He knew his telescope had problems and Newton wanted to figure out if maybe some of the everyday perceptions we had about the world might be due to defective optics in our heads as well.

Don’t stick anything in your eye. If you feel the need to stick something in your eye for reasons entirely unrelated to this column, please delete you browsing history before you do it, I don’t want to hear about it from aggrieved relatives!

Newton’s experiments do raise an interesting question, however. As we sit and think about our portfolios and how we invest, are we thinking with good tools? How well is our brain, so recently engaged in tribal warfare, adapted to the nebulous concepts of market value and risk-return curves?

Fortunately a fair number of researchers are doing work on how human (and in general mammalian) brains work. Some recent work by Professor Pascal Boyer of Washington University shows what happens when people are presented with scenarios in which they acted (choosing an envelope hoping to get certain contents) but their action clearly could have no influence over the final result (because the envelopes were filled randomly earlier). When the positive outcome happens (50% of the time) people uniformly express that they had an idea it was the right envelope or that they felt they were guided, and when the negative outcome happens those same people generally express regret because they had a feeling they were picking the wrong envelope and wished they had gone with their instinct. Throughout any number of experiments people generally attribute results to “nonphysically present agents” or forces that cause things to happen instead of admitting to randomness. People just can’t seem to admit to themselves that things in life are often random. Apparently this is the brain’s way of keeping us rewarded and motivated.

Before people start asking difficult questions about metaphysics let me move onto another experiment, this one involving rats.

In the rat experiment the researchers set out to test how long it took to unlearn things. Lots of people have trained rats to do various tasks, but what variables affect how long it takes them to give up?

First, the researchers put a large number of rats in cages with a foot bar. Each time the rat stepped on the foot bar it would get a treat. Soon the rats learn the rule “press the bar - get a treat”. Next the bars are reset so that in one group the rats get treat pellets every time they press the bar, another group gets a treat pellet every time they press the bar twice, another group every third press, etc. One group, however, had its dispenser set to dispense treats at random with no particular relation to the foot bar. Picture it for a moment: all those little white lab rats sitting in their cages merrily pushing down bars to get treats, some get one every time, some at random, but all of them know that the bar means a treat.

Now the interesting part, the researchers take away the dispenser treats and see how long it takes the rats to give up on pressing the foot bar. The rats who were getting a treat each press figured it out first, of course, and realized that the dispenser wasn’t giving them the goods anymore. The rats who needed two presses figured it out second, and so on. What do you think happened with the rats who were rewarded randomly? They wouldn’t give up. The rats who never really understood what the connection was between the lever and the pellet could never quite be sure what was going on so they kept right on pushing that bar long after the others had figured it out.

So what does this have to do with Isaac Newton and investing? Has the Finance Wonk gone loony?

Newton was trying to figure out the limits of his inbuilt instruments, and the workings of our brains should be just as important to those of us who use our brains as our instruments of investing. How many times have I noticed myself checking my stocks more often on days when they’re going down, as if the force of my attention would somehow get them to change course. Every investor gets it, the feeling that something is lucky: perhaps if you check your stocks first thing in the morning it helps, or maybe if you hold your breath a little while you first look at them each day. Anyone who has never felt any stock market superstition, not even once, please raise your hand so I can identify the liars in the audience…. thank you, your names have been noted. We all have that biological tendency toward assumption of “nonphysically present agents.”

Now comes the part where about half the crowd will want to tar and feather me.

Stock market “technical analysis” has a lot in common with that rat experiment. For those not familiar with the delicate art, “technical analysis” is the term used to describe a stock decision making strategy based on reading the shape of the chart of a stock price. It is contrasted with “fundamental analysis” which we typically do here involving analysis of a companies business and financial prospects. Decisions in technical analysis are often made based on shapely formations like a “head and shoulders” or “teacup” which supposedly predict upcoming movements. With a large enough data set there will always be plenty of cases to show examples of how it can work (these would be the random pellet rewards) but the relation is often unclear or statistically irrelevant. In defense of the sanity of practicers of technical analysis I would like to point out that modern charts are as precise as computers can make them so some methods (like trendlines and limit lines) are the equivalent of doing various mathematical functions on the stock price data. Unfortunately study after study has shown that no publicized technical analysis method works.

That last statement was carefully phrased. “Publicized” may be an important word here. In the 1980s economists first got their hands on computers and vast databases of past stock behavior. Looking through past data produced any number of papers. One of those was on the “January effect”: a pronounced tendency for a market rally every January. [As an aside the main effect in the paper was actually more of a small-stocks-in-January effect, but everybody calls it the January effect so who am I to argue.] Within two Januaries of the publication of the paper the effect was gone forever as millions of traders tried to get ahead of it and their neighbors. People still talk about the January effect because you still see some rallies in January (at random, which means we’ll never forget it if we’re anything like the rats), but trying to make money off it is a fools errand at this point. Maybe those teacup shapes and head and shoulder shapes made someone money once, but with thousands of adherents and lots of newsletters dedicated to trying to catch those predictive shapes first the only ones I think are making money off technical trading are the newsletters and brokers. If thousands of other people are trying to make money off the same information, it may not be the best bet. I actually will admit that I have my own little technical strategy but it’s based off massive statistical simulation, it hasn’t come up in a year, and I won’t be publishing it because it relies on a thin market in a particular backwater of the options trading world where even one more participant would ruin the profits.

So let us all stare into the mirror and realize that we are imperfect beings. We approach the world with our perceptions clouded and any number of superstitions and preconceptions which are nearly impossible to think about because they are, in fact, part of how we think in the first place. All we can do is try to be aware of some of our all-to-human weaknesses so that we can notice when we are falling prey to them and try to correct ourselves. This is a big part of why I heartily encourage arguing on this board, because it helps us all remember that nobody here is perfect and every conclusion is tinted by our limitations.

Long weekend for me; see you all Monday, The Finance Wonk
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