Tuesday, December 6, 2016

Lars P. Syll — Taking Uncertainty Seriously

Uncertainty and ambiguity are what make financial markets interesting and possible. They generate feelings that manifest in exciting stories, problematic mental states and strange group processes. As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable. They will also be likely to create poor outcomes for ordinary savers and significant distortions in capital allocation – exactly what we have been witnessing in the market today.
This is a key insight that Mike Norman calls "the mental game." Mastery of the mental game is a sine qua non of successful trading. It's also a sine qua non in many other field, such as negotiation.

Those that play without having mastered the mental game as the losers and the marks. They are the source of gain for the small percentage of players that have mastered the mental game.

The bottom line of the mental game is being able to deal efficiently and effectively with uncertainty and making uncertainty work in one's favor rather than against one. Uncertainty is scary when the market is moving away from one's position and the expectations taking the position was based on.

Market price is determined at the margin, therefore by traders rather than investors. Markets involved tug of war between the bulls and the bears, so to speak, in a conflict of opposite expectations — there are two sides of every trade.

In this process, both cognition and affect affect volition, that is, execution — taking a position and closing it out. Investors "buy and sell." Traders "take positions." Investors are not much concerned with changes at the margin while this is chief concern of traders. The affect is different. Investors are responsible for longer term and larger moves. Trades rule the short term and therefor change at the margin.

Cognition is affected by affect. Affect is not rational. Affect as a psychological category is opposed to the cognitive. Cognition is rational and affect is non-rational. Affect is not necessarily irrational in the pejorative sense, however.

Affect becomes irrational when it moves away from and even eventually contradicts the rational so that the subject progressively loses connection with reality.

For example, market prices in financial markets can vary widely with no actual change in fundamentals based on "expectations" that are dominated by greed and fear.

There are rational expectations based on cognition, but affect supervenes, affecting rationality, as the market moves and feedback on prior expectations.

As a result, markets depart from a linear path sufficiently for traders to arbitrage the variations, and they are successful to the degree that their mental game supports it.

Lord Rothschild is famously quoted as saying, "Buy when blood is flowing in the streets." He didn't need to add, "When everyone else is dumping." Easier said than done.

How to model this. Many, many traders have pondered this question, and so far if anyone has such a model they are keeping to it themselves.

 On the other hand, "experts" think it is clearcut.
Conventional thinking about financial markets begins with the idea that security prices always accurately reflect all available information; it ends with the belief that price changes come about only when there is new information. Markets are supposed to reflect new information quickly and efficiently, albeit with a few anomalies.…
Well, one could say that all change in price is due to some change in information that simply begs the question. Is that information based on fundamentals or market action, or market participants reaction to expectations about other market participants?

Lars P. Syll’s Blog
Taking uncertainty seriously
Lars P. Syll | Professor, Malmo University

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