Thinking About Money

If you’ve ever watched a financial channel on TV, you probably at some point saw an investment “expert” point to an extremely complex graph containing numerous odd lines and figures, and speak about trend lines and levels of support and other rather incomprehensible words that bore some vague resemblance to English.

This is called Technical Analysis, and it’s only now that I really have a handle on it, thanks to the book “Trading for a Living” by Dr. Alexander Elder. A book that you should probably avoid reading at all costs.

“Trading for a Living” is written by a psychologist. This may sound odd for an investment book, but in fact he’s the perfect author for the subject. Because Technical Analysis is neither math nor finance – it is an attempt to quantify psychology.

Let me explain.

Market prices and trends are as much an result of psychology as intelligence. People trade based on emotions such as greed and fear. And people tend to follow the crowd – if you hear reports on the news about how fast the market is rising, and how people are getting rich in stocks, and how it’s a true boom, sooner or later there’s a good chance you’ll dive in and invest so as not to miss out on the fun. The problem is of course, that by the time everyone is praising the rising market and you finally join, it starts dropping because the folks who got in early start selling to take their profits. Next thing you know the market is dropping like a rock and you start to panic and finally sell at a loss.

This phenomena happens all the time (see my earlier review on “Why Smart People Make Big Money Mistakes and How to Correct Them” for more on the topic). There have been booms and busts throughout history, the recent dot-com bust being only the most recent. If you’re interested in reading more on this topic, check out the book “Extraordinary Popular Delusions & the Madness of Crowds” by Charles MacKay – a truly extraordinary book that discusses numerous such boom and bust cycles.

What if you could measure these emotions? What if you could measure the degree of greed or panic or fear that is driving the market? If you could do this, you could perhaps detect when people were confident in the market and feeling greedy – buy stocks, and as soon as you detected a drop in confidence you could sell – before the market started dropping.

Hold that thought.

In Isaac Asimov’s classic science fiction series “Foundation,” Asimov invented a science called “Psychohistory.” The idea of psychohistory is simple: While the behavior of one individual is as impossible to predict as the location of a single atom, the behavior of large groups of people are predictable, just as the behavior a large group of atoms can be predicted (say, if you drop a brick you may not know the position of each atom, but you can safely bet the brick will fall, to the detriment of whoever may be standing under it). In Asimov’s book, he had a galaxy of people to work with – many trillions even, and thus human behavior could be predicted accurately even hundreds of years ahead of time.

Technical Analysis is a form of psychohistory. It is the application of mathematics to measure and then predict human behavior. Unfortunately, technical analysis (at least as practiced by most) has the same relation to psychohistory as alchemy has to chemistry. Sometimes it may seem to work, but it’s predictive ability is limited (assuming it exists at all and the positive results are not blind luck).

Here’s a related example. Early in my career I wrote software for the solar energy industry. Part of the our job included an economic evaluation of a project – basically figuring out how long it might take for the energy savings to pay for the cost of the system. Some things we could calculate with some accurately – how much solar energy reaches the earth is quite predictable for a given location. The big unknown however is cloud cover. It’s easy to calculate how much energy will be captured by a solar collector in perfect cloudless conditions, but how often does that happen?

We did have government estimates for cloud cover at various locations for various times during the year. So we ended up developing a variety of equations to estimate the cloud cover. In the end they did a great job calculating past cloud cover – but when it came to estimating the future… well, things weren’t so great.

Technical Analysis does a great job at allowing you to understand why things may have happened. But can it predict the future? At least when we calculated cloud cover we had certain basic facts like solar output to work with. Technical Analysis seems to have much less. Its fundamental flaw is that even if it can predict the impact of emotion on market behavior (which is far from certain), it can’t predict the underlying stimulus. In other words – if the Fed hints they may increase rates, and a few gurus predict falling stocks, a Technical Analysis system can measure the panic that ensues as or after in ensues, but can’t predict how great a panic if any will actually occur for a given stimulus. And with today’s glut of available information, there is a LOT of stimulus feeding into the system.

I did not study the book “Trading for a Living” in detail. The book goes into a great deal of effort to teach various indexes, equations, charts and systems for predicting market moves. However I did read a lot of the general information, and I do believe it is a remarkably honest book.

The author is very clear that what he is trying to predict is human behavior in crowds – and though he does not mention Asimov’s psychohistory by name, that is clearly what he is talking about. He is quick to admit that any system will only work for a brief time – a tacit admission that the equations represent a relatively narrow time window and reality. He himself calls Technical Analysis as much an art as a science, and is quick to dismiss systems that are generally sold by advisors at inflated prices.

The book is also written for people who are serious about trading – not investors. Traders are those who really work at trading stocks, options and futures. Trading is a tough game, and one that most individual investors play at a loss. Though perhaps not actually gambling, my sense is that traders ultimately share a similar mindset to gamblers – their goal is to beat the system, or beat the other players. In each trade there is a winner and a loser (which differs from investors, where it is possible for many to win because actual wealth is created). Trading is for those who are trying to gain very rapid returns – though the author is quick to note that most of those who do, succeed through luck rather than skill, and often give up their gains soon after.

Can technical analysis work? Personally, I think psychohistory does make sense – human behavior should be more predictable in crowds than as individuals. but if anyone has the ability to actually calculate this with today’s technology, it’s likely the big trading houses with their complex models created by math PhD’s, not the individual trader.

There are trading techniques described in the book that I believe could be of use to investors. Certainly most can do better calculating and managing risk. Using stops to limit losses and options to manage risk are techniques every investor should be aware of. But I suspect there are better books for this. “Trading for a Living” is not a book I would recommend for the individual investor, though I’m glad I read it for the fundamental understanding I have gained over that aspect of the investment world.

Reviewed: “Trading for a Living” by Dr. Alexander Elder

This entry was posted on Wednesday, June 7th, 2006 at 8:40 pm and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.