Negative Marking

I am not sure if my readers have encountered MCQ tests/exams (CFA exam format of past) whereby there is a penalty (deduction of marks) for wrong answers. Correct answers are awarded a full point of course. This is the clearest example of a situation with negative marking. What has this got to do with approaching the investment markets? A big deal actually.

Psychological effects of negative marking.

Put yourself in the hot seat taking such an exam. Examine the mental conversation going in your head. Do you know the answer to score a full point? What if you think you are right but you are wrong? Do you really want to randomly pick an answer? You would realise that at times, it is better to not answer the question at all? It is all because there is a consequence for being wrong. In the case with investment markets, you lose money.

How can the investment market screw your thinking? It does this by rewarding you for doing the wrong thing, (you got it wrong but you made money) and punishing you for doing the right thing (you did right but lost money).

The larger the consequence, the larger the psychological impact.

Suppose you have an approach/method to the market, and it has been doing pretty well a couple of times. Even if the method brags a 90% hit rate, the fact that you up the position size and the 10% probability event happened, you will seriously doubt the method as you lick your wounds. The position size directly links to psychological impact outcomes and of course, no position no risk (as good as not attempting the question or engaging the market at all) which at times, not a bad thing.

There may not be anything wrong with the method, but rather the position size taken that led to this outcome where you ditch the method. But frankly, the market condition could have changed to render the method unsuitable moving forward. Who objectively knows?

Isaac’s style and approach.

I am a proponent of the adaptive market hypothesis. Every technical indicator (so many) and fundamental analytic metric (plentiful) is testamentary proof that it once provided good probability outcomes (ie 80% in the past but now 53%) for mainstream usage and subsequently experienced declining efficacy. This by the way, proves that forward statistics are not stable.

Way too many people approach the investment markets by putting the cart in front of the bull. Getting hung up on the method, searching for the holy grail with extensive back-testing and excessive intellectual masturbation with quantitative justifications. Study the charts and adapt the methods to the market state. It is not about expanding the knowledge of methods and approaches, but knowing them in depth to understand when they work and when they don’t. Apply accordingly.

Have I been wrong before? Yes, but my clients’ ports and my own ports are not impacted beyond repair (ie crippled or accounts blown) as I am mindful that a 50% loss requires a 100% gain to break even. Yr2018 has been challenging. I underestimated the duration extent of the pullback to decisively short the market. Position sizing and overall portfolio management to diversify methods and approaches even, become significant. Everyone can have a view, and the market can accommodate them all with some losers and some winners.

George Soros said,

“It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.”