In today’s issue, we explore how market participants can be deceived by themselves and others.
Truth
If the doors of perception were cleansed every thing would appear to man as it is, Infinite. For man has closed himself up, till he sees all things thro’ narrow chinks of his cavern.
— William Blake, The Marriage of Heaven and Hell
Success in markets largely depends on the ability to see things as they are, not as you wish them to be.
The market has its own reality. As an example, Apple closed at $188.63 on the day of writing. To buy or sell Apple shares, it must be done near this price. Asking for $200 a share will not find takers when the market bid is cheaper. Bidding $160 a share will not attract sellers when the market ask is dearer.
As market participants, we must operate within the market’s constraints. The market, for lack of a more potent term, is our master. If we cannot submit to the rules of the game, we will be punished. This means losing money, a painful prospect! In markets, it is far better to be careful, observant, and planning than it is to be quick, scattered, and adventurous. As we gain intuition and experience, we will be more able to capture opportunity when it beckons.
Seeing things clearly is challenging, but we can start by cataloging our preconceptions.
Bias
Hypocrite! First remove the plank from your own eye, and then you will see clearly to remove the speck from your brother’s eye.
— Matthew 7:5, New King James Version
Countless biases exist, do you believe you are unscathed?
The ugly truth is that we are all biased. Unchecked bias can be the difference between fortune, mediocrity, and ruin for investors. Your beliefs and actions matter in the world at large, but check them at the door when trading markets. The market does not care what your political and religious beliefs are. The market does not care if you are hungry or upset. The market does not care if you “need the money.” The market is doing its best to take your money! It is a zero-sum game. When you win, someone else loses, and vice versa.
Unchecked bias can be the difference between fortune, mediocrity, and ruin for investors.
Examine the following common biases and note which ones afflict your thinking (AI assisted).
Information processing
Anchoring: Relying too much on initial information.
Apophenia: Seeing patterns where none exist.
Availability heuristic: Judging based on what is easy to remember.
Bandwagon effect: Adopting popular beliefs regardless of personal opinion.
Confirmation bias: Focusing on things that align with existing beliefs.
Framing effect: Deciding based on how information is presented.
Hindsight bias: Thinking you knew something would happen all along.
Self-awareness
Egocentric bias: Believing the world revolves around you.
False consensus effect: Overestimating others’ agreement with you.
Illusion of control: Believing you have more influence than you do.
Overconfidence effect: Thinking you are better than you are.
Planning fallacy: Underestimating how long things take.
Decision making
Escalation of commitment: Sticking with a bad decision due to the time or money invested.
Gambler’s fallacy: Believing past luck affects future events.
Loss aversion: Hating to lose more than loving to win.
Prospect theory: Making choices based on potential emotions, not just logic.
Status quo bias: Preferring things to stay the same.
Others
Dunning-Kruger effect: Unskilled people overestimate their ability, experts underestimate.
Impostor syndrome: Doubting your skills and fearing exposure as a fraud.
Two biases immediately stood out as particularly relevant: the bandwagon effect and confirmation bias. Analyzing the past two years through the framework of these biases could offer valuable insights.
Buffalo Jump
The bandwagon effect is rampant in markets. Most people are comfortable being part of the “herd” in finance, or else it would not exist! Confirmation bias is also rampant. People see the world as they like to see it. In markets, participants develop theories about the economy, its direction, and its impact on the market. Some of these theories become popular. Consider all the groveling we have endured for the past year and a half about a recession! Meanwhile, the market moved based on actions, not beliefs.
The graph above shows the S&P 500 E-mini futures (ES1!) and its associated positioning data at the bottom. Positioning data is from the weekly Commitments of Traders (COT) report by the Commodity Futures Trading Commission (CFTC). Jason Shapiro is a good source for more on this technique. I like to balance my positioning indicator as follows.
To laymen, asset managers may seem sophisticated, but are often as biased as their clients. We can call them “dumb money.” Dealers and commercials, termed “smart money,” often use automated processes for decision making. They are not always on the right side of a trade, but they are more frequently on the right side of a trade.
The bandwagon effect is partly driven by confirmation bias. As the bear thesis played out and seemed accurate, more people shorted the market. A few profited, and then everyone wanted to do the same. The ES1! index declined -24.5% from December 2021 to October 2022. During the same period, our positioning indicator declined by -93.8%! Being bearish was popular, but, just like in June 2020, September 2015, and October 2011, it was a bad time to be short the market.
Eventually, the herd is slaughtered. Whether a gang of bulls or a sleuth of bears, avoid being in either! The current market buzzword is “soft landing,” believed by the majority of economists according to the National Association for Business Economics (NABE). Pay close attention to this narrative, it may be as wrong as early calls for a “recession.”
Deceivers Galore
All warfare is based on deception.
— Sun Tzu, The Art of War
Trading is not a team sport.
Your broker is not your friend, neither is Jim Cramer, and especially not some random guy on Twitter. Assume most information in finance is incorrect or misleading. Some might call this cynical, but when it comes to your money, trust must be earned. If we want to be hermetic about it, retrieve price quotes from the NYSE or Nasdaq, fundamental reports from EDGAR, and news releases from PR Newswire. This may be too acetic for many, but it covers all the bases and minimizes incorrect information.
Assume most information in finance is incorrect or misleading.
Every entity deserves skepticism, many have blatant vested interests. Whenever you see the phrase “sell-side,” they are more interested in getting you to buy an investment or subscribe to their service than profit from it. Here is a short list of companies that deserve your scrutiny (AI assisted).
Sell-Side Firms
Investment Banks
Bulge Bracket: Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America, Citigroup
Middle Market: Jefferies, Evercore, William Blair, Baird, Piper Sandler
Boutique: Greenhill & Co., Moelis & Company, Perella Weinberg Partners, Lazard
Brokerage Firms
Full-Service: Merrill Lynch, Charles Schwab, TD Ameritrade, E*TRADE, Fidelity
Discount: Robinhood, Interactive Brokers, Firstrade
Online-Only: Webull, SoFi Invest, Stash
Market Makers
High-Frequency Trading (HFT) Firms: Citadel Securities, Virtu Financial, Jane Street, Susquehanna International Group
Specialist Firms: IMC, Cantor Fitzgerald, Hudson River Trading
Designated Market Makers (DMMs): BATS, NASDAQ, NYSE Arca
Sell-Side Finance Media
News Publications
General: Bloomberg, Reuters, The Wall Street Journal, Financial Times
Industry-Specific: Markets Media (Private Equity), The Deal (M&A), Institutional Investor (Asset Management)
Research Providers
Terminal Providers: Bloomberg Terminal, Thomson Reuters Eikon
Data & Analytics: FactSet, S&P Global Market Intelligence, Morningstar, Moody’s Analytics
Equity Research: Credit Suisse, UBS, Bank of America Merrill Lynch, Jefferies
Despite widespread bias, you must put trust in something, but please do your homework first. For instance, I use Yahoo Finance and MarketWatch for quick looks, but I have found inaccuracies in their data, so I check EDGAR before trading. I also use Charles Schwab, TD Ameritrade, and Vanguard to manage my accounts, but I have found my broker feeding me false spread data to shake me out of a trade. Why else would the bid on an option with an open interest of five update by the second? Why does it lower once I put in my ask? Why indeed.
Your portfolio manager wants you to profit only after they take their fee, your broker wants you to profit only after they take their spread, and Jim Cramer wants you to profit only after he uses your bid as exit liquidity! When it comes to markets, the mindset is “do for self” for nearly all its participants.
Conclusion
The only true wisdom is in knowing you know nothing.
— Socrates
Not wanting to end on too bleak a note, consider that by accepting the ugly truths of finance (a topic much deeper than explored here), you can more realistically approach the task at hand. Your task is to extract profit from the market, like any other participant. If your preconceptions or others’ deceptions affect your performance, step back, find the bias, and do your best to keep it in check.
Investing is inherently difficult, but navigating your own biases and maintaining skepticism for self-serving actors can lighten the load.