Financial Markets, Sensory Perception and Mental Models.

We like to think that our senses lead us in the right direction, enabling us to make optimal choices based on our perceptions of reality.

However, often our senses, particularly when faced with complex situations, can distort reality and lead us to make incorrect inferences and false conclusions.

Illusions provide good examples of this. Take a look at this checkerboard illusion below and see if you can tell which square is darker, Square A or Square B?



Spoiler Alert: Square A and Square B are the same colour and shade!

Here is a link to a clever YouTube video which proves the illusion. Whilst here is another a link to an explanation from the clever guys at MIT.

All is Not What It Seems.

My work as a performance coach in financial market involves me undertaking deep conversations with investors and traders about their processes.

I am also helped in this by my studies in Gestalt Psychology, which deals with perception and helps explore beneath the surface, and over 20 years’ working as a trader.

One thing that continues to surprise me, is the many creative ways different traders and investors use to help navigate a path through the minefield of financial markets. Just when I believe that a particular method or approach doesn’t work, someone will come along and prove me wrong.

However, it is when I go deeper into exploring their approach, that I then find all is not what it seems on the surface. Often the method they espouse is not as much the root of their success as they think it is.

Some years ago I coached a very successful private trader who had decided he would teach his method to other traders whom he could then fund and take a cut of their profits. A kind of mini turtles programme.

He took on several trainees and spent considerable time teaching them his method and approach. However, with one exception, none of these trainees were able to make his method or approach work. Even the one exception did not truly follow his method, instead he applied his own unique style.

The trader was puzzled as to why these individuals could not replicate what he was doing. After we investigated his approach and method, he started to realise that the approach he was using, based almost entirely on price action, was not really his edge. At the point of action, he was adding his own twists based on his intuition.

The analysis of price action was important, it took him to the point of action. But it was not the deciding factor which made him take or exit a trade.

Suddenly it dawned on him that he had been teaching these individuals a technique which had no edge. The edge he did have was unique to him and was intuitive and largely unconscious.

The Best Guess and Mental Models.

The trader mentioned above's model was effectively a ‘mental model’. At the point of action it relied on an educated guess. He was not takening every single signal, sometimes he was taking it when it happened, other times, dependent on his reading of the situation and ocntext, he would hold off for a bit. Human judgement was involved, and this made it incredibly difficult to replicate, let alone explain.

It is an uncomfortable reality for many, but trading, and even investment, rely to a high degree on ‘guessing’. Even systematic processes require human judgement somewhere in the construction process, and again in the management and maintanance process.

For those uncomfortable with the idea of being engaged in guessing activities, the term ‘Bayesian Inference’ may prove more comforting.

Bayesian Inference is a term which encompasses the ‘educated guess’, rather than random guessing process.

All models help improve the guessing process by reducing noise and providing a way to navigate complexity. n the above example the traders method and approach added up to his model. Other models may be more open to description, such as quantitative models and systematic approaches.

I wrote an article some years ago on Keynes the investor. In it I described how it was not Keynes’s vast knowledge of economics which ultimately proved to be the deciding factor in his success as an investor, but a model he applied which he described as akin to a 'Beauty Contest' approach to stock picking.

This approach (model), which an early forerunner of ‘value investing’. It embraced, as does Warren Buffeet and Charlie Munger, to a high degree the idea of ‘educated guessing’.

Analysis informs, but it is rarely enough on its own. Success in the financial markets relies on models in some form.

Steven Goldstein is a leading Performance and Executive coach who helps people, teams, leaders and businesses in the financial markets to cultivate better, stronger and more effective performance.

Steven has worked as a coach since 2009 with many significant trading and investment businesses. Prior to that Steven worked for more than 20 years on the Rates and FX desks at some of the world’s leading investment banks.

See Steven's Full Profile.

Alpha R Cubed work with people and businesses in the financial markets to help them explore how they could help improve and develop behaviour to catalyse stronger and more effective performance.

We run coaching and development programmes for individual and teams engaged in Financial Market activities. In addition we help Financial Market businesses develop 'Organisational Effectivessness.

If you are curious about how we could help you or your business, please email us at info@alpharcubed.com. or call +44 (0)7753 446097.

It has always been a 'Post-Truth' world

Tthe Oxford Dictionary has declared “Post-truth” as its 2016 word of the Year. "Post-truth" refers to circumstances where ‘objective facts’ are less influential in shaping public opinion than emotions and personal belief. As the big political 'shock' events have unfolded this year, commentators have come to increasingly apply the term ‘post-truth’, to make sense of the how the electorate have ignored facts and voted with their hearts. However, this ignores a crucial 'fact', people have always voted with their heart. In his 2004 book, 'Don’t Think of an Elephant!' George Lakoff, said that voters were motivated more by “moral identity and values”, than economic self-interest.

Politics and markets are two sides of the same coin. Anyone who has worked in markets long enough, has known that heart come before head. The lengendary investor Benjamin Graham called it right, when he said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” - Yes in the long-run, facts matters, the market will only stretch so far from value, however markets can stay irrational far longer than many can remain solvent, and in that sense it has always been a post-truth world.

Complexity and Uncertainty.

Thw one and only truth is that the world, as with markets, is inherently complex and uncertion. In  an interview back in the 1980s, when he was head of currency forecasting at the Federal Reserve, Kenneth Rogoff was asked 'What exactly did being head of currency forecasting mean?'. His response “It means that I know better than anyone else, exactly how much I do not know where markets are heading.”

Markets rarely conform to what appear to be ‘the facts’. It is human emotions and feelings that tend to drive markets. This may seem illogical to many, but was perfectly understtod by John Maynard Keynes. Keynes used the term "animal spirits" to describe how human emotions drives crowd behaviour and the way people make decisions in markets.

Keynes' own experiences as an investor were a key factor in helping him come to these conclusions. Keynes had been responsible for managing the endowment fund of King's College at Cambridge. His early experiences were less than impressive. From 1924 to 1932 he only marginally outperformed the underpforming UK stock market. Yet it was during these times that Keynes, as the world’s leading economist, was as informed as anyone could. He had the ears of presidents, prime-ministers, finance ministers, heads of central banks, heads of mining companies, leading financiers, and anyone who was anyone in the financial and political world.

Post-1932 however Keynes's investment record was stunning. The table below, lifted from a 2012 Wall Street article, emphasises this. It was during this time that Keynes became the pioneer of what was to be known as Value Investing. Keynes’s method was to have a huge influence on the legendary Benjamin Graham, and one of his prodigys, Warren Buffett.

From 1932 onward, Keynes abandoned his practice of looking at the big macro factors to determine value, instead he took a bottom-up ‘micro’ approach. The truth based on objective data, was less important than trying to understand what 'moved' and ‘motivated’ people to value an asset. If he could understand and price that, then he could pick stocks which had a strong possibility of moving higher. To emphasise this, Keynes used as an example, what became known as the Keynesian beauty contest.

The Keynesian Beauty Contest.
Keynes compared selecting investments to the way people particpated in beauty contests common at the time in English newspapers. The newspapers would publish 100 photos of beautiful women, and asked readers to select the six faces they liked most. The winning reader would be the person whose selection most closely matched the six most popularly selected faces, or some variation of that. Keynes wrote that “It is not a case of choosing those (faces) which, to the best of one’s judgment, are really the prettiest, nor even those which average opinions genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be."

2016 - Brexit and Trump

2016 has been a huge challenge for many who are trying to rationalise events which challenge their view of the world. What they are seeing, what they believe they know, and what has happened seem completely at odds. It becomes far easier for them to explain this, by applying terms such as ‘post-truth’ or ‘post fact’. - In my formative trading years, I wish I could have explained losses I suffered as ‘post-truth’ or ‘post-fact’ events, it would have saved me a lot of anguish. Actually, as I recall, I may have done that: I once said ‘It wasn’t me that was wrong, it was the market’.

The problem is that our minds do not necessarily work in ways we think they do. All our experiences, knowledge and expectations accumulated over many years shape the way we see the world, often taking us away from reality. Optical illusions are often a great example of this. In this chessboard image below, squares A and B are exactly the same colour, yet even as I tell you that, with every sinew in your body you will believe this to be complete nonsense.

This is one of my favourite illusions. I often lead with this one on 'Behavioural Finance' seminars and workshops I give. No matter how much I try and tell people that square A and square B are identical colours, no one believes it. And even as I look at it now, knowing full well the truth, I cannot see it.

‘Markets and politics’, two sides of the same coin, do the same thing to us. Thus we rarely see matters as objectively as we think. We try to resolve these issues in a variety of ways. If I draw on this illusion as an example. We can either dismiss what we see, and trust the story, in this case the idea that square A and B are identical colours. Or we can dismiss what seems ridiculous and hold the opinion that Square A and B are different colours. Or if you have the time and energy you can do your own research (I have provided a link to assist you ). Or you may prefer to print it out and cut it up to prove (or disprove) me.

Returning to this year’s earth shattering political events:

In January you could have got great odds from bookmakers on both Brexit and Trump. You could have still got great odds in the first few minutes of both days of those events occurring. In January I was having breakfast with one of the markets leading, least known, yet most brilliant of economists, Martin Malone. Martin asked me what I thought would happen regarding Brexit and the US election. I said that the chances of a UK Brexit vote were incredibly low. Polling at the time had Brexit in the mid to low 30 percent. He looked at me, and laughed, ‘It’ll be a lot closer than that he said’. Adding, that he thought it would actually happen, and that he would fully expect the pound to drop to about 1.2500 to the dollar. As for the US election: I said, the idea of Trump getting elected was laughable. Again, the look on his face told me that once again his view differed.


What Martin does, as an economist, is he digs behind the numbers, he goes outside the ‘bubble’, he gets a truer understanding of the facts, and being privately employed he is not influenced by both conscious and unconscious agendas. More importantly, he builds a bottom-up case, and he certainly does not take anything at face-value.

Post-Truth = Inconvenient Truth.

I do not want to disseminate the various statements used along the way in the referendum/election processes, this is not a political piece, other than to state that politicians lying or grossly exaggerating is nothing new. What I will say however, is that the term ‘post-truth’ is being used to try and square the 'cognitive dissonance' and 'inconvenient truths' which has arisen for many people this year.

These days I no longer trade for a living, instead I work as a coach with traders and investment professionals. In doing this, I have come to appreciate many of the finer qualities and subtleties I see displayed by the finest exponents of making money and managing assets in financial markets. One of these is the ability to admit when one is wrong and to not be too dogmatic in one's views. Many of the best traders and investment professional I meet will readily admit that they know far less about where markets are headed than many people think. ‘Not knowing’ and ‘Being wrong’ are OK for them.

This attitude echoes the response Keynes once gave to an irate government minister who had accused him of reaching a conclusion which was contrary to that which he has previously reached. ‘When the facts change, I change my mind. What do you do, sir?’

The fact or the truth is, that we do not live in a ‘post-truth’ world, we live in a highly uncertain, highly complex world. We always have done and always will do. The big mistake is to confuse 'more knowledge', with 'better knowledge'.