Drunkards Walk book

March 14, 2018

WHY ALGORITHMIC TRADING???

Human beings with our animal brains are very poor decision makers, and not really suited to making buying or selling decisions based on far more information than our meat computers can process. This is why objective, tested algorithmic trading is always going to be more profitable.

Excerpts from “The Drunkards Walk”

Which is greater: the number of six-letter English words having “n” as their fifth letter, or the number of six-letter English words ending in “ing”? Most people choose the group of words ending in “ing.” Why? Because they’re easier to think of than generic six-letter words. But the group of six-letter words having “n” as their fifth letter includes all six-letter words ending in “ing.” Psychologists call this the availability bias, because we give unwarranted importance to memories that are most vivid and most available for retrieval.

Suppose the state of California offered its citizens the following game: Of all those who pay the dollar or two to enter, most will receive nothing, one person will receive a fortune, and one person will be put to death in a violent manner. Would anyone enroll? They do – it’s called the state lottery. Applying statistics from the National Highway Traffic Safety Administrations, you find a reasonable estimate of driving fatalities is about one per game.

Are streaks in sports real? Not according to a 1985 study by researcher Amos Tversky. He investigated reams of basketball statistics and found that better players have a higher chance of scoring, but their chances of a successful basket after scoring a basket was the same as after a failure.

This above statistic is exactly the same as mutual funds. Statistically, the chances of a mutual fund beating the index this year, if it has a track record of beating the index for 1,5,10, or 20 years in a row is the same chance as any other mutual fund - or the same as a basketball player on a winning streak. Our human brains cannot process this amount of data, so we sift through 10,000 funds looking for the most winning funds that beat the market 10 years in a row without considering the VERY LIKELY chance that those magically amazing consistently winning funds would exist in a large sample size of 10,000 funds, just by chance alone!

That last excerpt is a good analogy for the mistakes we make when making discretionary trading decisions. There is a situation which I have proven is statistically RANDOM but most traders, once this pattern is recognized, will assume that the pattern will continue to repeat itself into the future. In fact, this trend line pattern occurs AS OFTEN in RANDOM PRICE data as it does in actual price data!

 

 

 

 

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