Nov 152012

Nate Silver is a stats geek and a political wonk. He sharpened his predictive ability by playing hundreds of hours of poker, and building an analytical system for major league baseball. His successes in statistical analysis make him more than credible on the topic of prediction.

The Signal and the Noise is a book about the failures of our societal elites to accurately make predictions in various technical fields. Particularly in areas like Economics, Meteorology, Financials Markets and Politics. I found this book to be so interesting because it re-affirmed many of the complaints i’ve had with the financial services industry as a whole.

In the first few chapters, Nate discusses a clinical study that was done were participants were classified as either “Hedgehogs” or “Foxes”. Hedgehogs were defined as people who were confident (overly) with rigid belief systems that are infused with superego. Hedgehogs had a tendency to ignore empirical evidence if it clashed with their worldview. They tended to excel in areas were presentation, bravado, and hubris are the necessary skill sets. Foxes, on the other hand, are almost insecure in their presentation. They are very detail orientated, open minded people. Foxes make decisions with more of a Bayesian approach. If a Fox is presented with information that is conflicting with their belief structure, they simply adjust their opinion to reflect the objective reality.

HedgeHogs in Finance

Although Nate Silver’s description of the Hedgehog group does sound rather unappealing, I believe that everyone can add value in our society, even if its just entertainment value. I think the issue with the investing/trading community is in the crowning of our so-called experts. The investment community has been flooded with resume’ touting salesmen that are NOT domain skilled practitioners.

I want a Fox managing my MONEY 

Recently, I had to the opportunity to meet several local (dallas) successful traders through the stocktwits community. @bluehorshoe Josh Reese, @prolongwealth Charlie Baker, and a trader i’ve actually known for a while @attitrade Darren Miller. All of these guys have Fox-like traits. They’re humble, down to earth, and ego-less. Most importantly, if you actually talk to them about how it is they support themselves via trading, you will see that it is very difficult to get a smooth coherent blueprint out of them. The main reason for this is : THEY AREN’T SALESMEN. They’re traders who adjust and contort to the market in hopes of taking a hefty profit home at month’s end. These are the types of people I want managing my money.

 The perils of academic Finance

The book  devotes a solid amount of time to academic finance. For me, this was the best part, because the  lack of accountability in academia is deplorable. Eugene Fama is highlighted in the book as being the Father of Efficient Market Hypothesis (EMH)  which states that the markets are essentially efficiently priced and because of that nobody can beat the market over the long run. This theory is at the core of most of option pricing models that we all use everyday. The problem with this is that for decades before Fama’s theory and for decades after it went public, there have been a consistent group of individuals that outperform the market by leaps and bounds. Despite years of contradictory evidence, most academics still hang onto this theory as if it’s hard science.

It was the salesmanship of Fama and others that influenced so many money managers and universities to adopt the ideology as religion. All the while, Fama was investing his own money with the likes of Commodity Trading Corp and Warren Buffet. I guess even Fama didn’t believe his own pseudo-science.

Lessons and takeaways for private investors

1. Learn to play poker or some strategic game- Nate Silver talks significantly about the the nuisances of poker. One of the keys to success in poker, as outlined in the book, was the player’s ability to make high quality decisions given all the current information available. Sounds alot like trading doesn’t it?

 I cannot emphasize this enough, the best traders are the best decision makers. Whenever I review my bad trades, I almost always conclude they were rooted in my own poor decision making.  I admittedly am not a poker player, but I am definitely going to learn.

2. Ditch your ego- If speculating in the market is your career choice, then you cannot afford to be an idealogue. Allowing political opinions, superstitions, or petty grievances to affect your trading decisions is recipe for disaster.  Adapt to new information, and be willing to admit you’re wrong

3. Don’t worship financial models- This one applies to me especially. I have been burned myself by placing too much weight on option probabilities in lieu of common sense. As much as I love Black-Scholes, stock prices move much more violently than any model could ever predict. Models are tools, not trading strategies.

Lastly, if you haven’t read the book please consider it. With the holidays coming up, we will all have some spare time on our hands. I hope this was helpful, feel free to tell me what you think in the comments section.


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— Darrin

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