The Fallacy of Market Prediction

The Fallacy of Market Prediction

Spoon boy: Do not try and bend the spoon. That’s impossible. Instead… only try to realize the truth.

Neo: What truth?

Spoon boy: There is no spoon.

Neo: There is no spoon?

Spoon boy: Then you’ll see, that it is not the spoon that bends, it is only yourself.

~ The Matrix

Traders and investors are faced with a seemingly intractable problem when participating in markets — they must place bets on future outcomes which are unknowable even as they’re cognitively wired to be risk averse when faced with uncertainty.  

Put simply: unknowable future + human desire for simple answers = problem.

In this piece we’ll briefly discuss how most people square this peg and also the correct framework you should use instead.

The Brain Is Lazy

The brain is an amazing piece of hardware. It’s comprised of roughly 90 billion nerve cells which are linked together by trillions of synapses. It’s estimated that the human brain operates at approximately 1 exaFLOP. That’s equivalent to a billion billion calculations per second, multiples faster than what the largest supercomputer can accomplish over any meaningful period of time.

But all this processing power takes up a lot of energy — a bit over 20% of the body’s total usage — making it by far the most energy intensive organ.

Because of these large energy needs, the brain has evolved like the rest of the human body for maximum efficiency. After all, the primary driver of evolution is survivability, and energy sources (food) used to be scarce. So the human body evolved to balance a brain that can solve complex tasks — helping us move to the top of the food chain — with a need to efficiently use the body’s energy.

As a result, we got a brain that’s awesome, but also lazy.

It uses a host of cognitive tools (ie, heuristics, biases, anchoring, etc.) as a way jump to conclusions without expending too much energy consciously thinking through every single problem it’s faced with.

For the most part, this system works great. The brain is unmatched in its ability to subconsciously perform pattern recognition and come to an adequate conclusion with little information.

This process is described in Daniel Kahneman’s classic book Thinking Fast and Slow. Kahneman breaks down the cognitive functioning of the brain as follows:

  • System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control.
  • System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.

The automatic operations of System 1 generate surprisingly complex patterns of ideas, but only the slower System 2 can construct thoughts in an orderly series of steps . I also describe circumstances in which System 2 takes over, overruling the freewheeling impulses and associations of System 1. You will be invited to think of the two systems as agents with their individual abilities, limitations, and functions.

Systems 1 and 2 are both active whenever we are awake. System 1 runs automatically and System 2 is normally in a comfortable low-effort mode, in which only a fraction of its capacity is engaged. System 1 continuously generates suggestions for System 2: impressions, intuitions, intentions, and feelings. If endorsed by System 2, impressions and intuitions turn into beliefs, and impulses turn into voluntary actions. When all goes smoothly, which is most of the time, System 2 adopts the suggestions of System 1 with little or no modification. You generally believe your impressions and act on your desires, and that is fine— usually.

When System 1 runs into difficulty, it calls on System 2 to support more detailed and specific processing that may solve the problem of the moment.

We’re not going to go into more detail here on the benefits and disadvantages of the System 1 and System 2 model, nor the host of tricks the mind uses to make this system function (here’s a cool Bias Codex). Those have been covered elsewhere and if you play in the markets, then you should just read the book. It’s worth your time (side note: Michael Lewis’ new book is a good primer on Kahneman).

All you need to know is that the brain evolved to seek out simple, linear answers when confronted with complex situations, especially where there’s an information deficit.

Basically, the brain is not well suited for markets.

Squaring the Peg: How Most People View Markets

For the many advantages that our brains offer, they can be extremely dangerous to our trading capital.

That’s due to the following two reasons:

  1. Our brains operate on pattern recognition and therefore like simple, linear answers.
  2. Information overload results in cognitive tunneling (System 1 thinking) and our minds instinctively follow the path of least resistance when confronted with complexity.

The problem with “reason 1” is that markets are not simple or linear. They are endlessly complex and dynamic.

Therefore “reason 2”, following the path of least resistance in coming to conclusions, is the opposite of what you should be doing.

These cognitive handicaps lead people to think that prediction in markets is possible. It’s not.

The prediction fallacy is based on the assumption that the future is fixed (linear) and all important variables are known (total information). This is, of course, patently false.

Regardless, many of us still subconsciously use this mode of thinking as our primary mental model.

Here’s a sketch of how most people think about markets.

How Most People Think About Markets

Simple and linear.

Here is how slightly more “sophisticated” market participants think about markets.

How Slightly More Sophisticated Market Participants Think

This is better than Figure 1, but still wrong.

To think in probabilities is to give a statistical weight to different outcomes. But this statistical weight is useless — sometimes worse than useless — because a number of essential variables will always be unknown. On top of that, you can never know just how many of these unknown variables there are. Therefore the situation is not actually calculable, nor repeatable.

Thinking in probabilities leads to false confidence and suboptimal outcomes.

The market isn’t like Poker where assigning probabilities using known variables and experience makes sense.

In poker, things are quantifiable. You know how many cards are in the deck and you can calculate probabilities for your hand and the other hands at the table. You can then use these in conjunction with bet amounts to arrive at a statistically meaningful edge where you can surmise both pot odds and the expected value of your actions.

Of course, like in all things, there are some exceptions. Quant and algorithmic traders, for example, exploit inefficiencies, quantitative correlations, and other relationships to find statistically meaningful edges. But these are often very short-term and eventually always get competed out of the market. This is why quant funds need to continually evolve to find new edges.

Since most of you aren’t Jim Simon, this exception probably doesn’t apply to you. Most of us are left using our minds in the best way possible to arrive at better outcomes.

How You Should Think About Markets

“As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” ~ Donald Rumsfeld (emphasis mine)

Markets are full of unknown unknowns.

No matter how smart you are, or the amount of advanced tools you have at your disposal, or even how much exhaustive research you do, you’ll still be partially blind when putting on a trade.

And the dangerous thing is… you can never know exactly how blind you are.

We need to implement a better mental model for markets when dealing with these unknowns.

Possibilities not probabilities.

Probabilities imply linear and rigid known and unknown outcomes. They instill false confidence.

Possibilities imply the dynamic, fluid acceptance of unknown unknowns. They confer insecurity.

Thinking in possibilities instead of probabilities not only makes you a better risk manager by stripping you of your overconfidence, but it also primes your brain to avoid fixating on a single set of outcomes.

Fixating on a single set of outcomes wires us to look for confirming evidence while blinding us to opposing information. This is called confirmation bias. This bias tends to become more powerful the more time you sink into researching an idea (sunk cost bias).

Thinking in possibilities keeps our minds open to competing and opposing information. This is absolutely vital for any trader or investor who wants to have long-term success in markets.

It’s the whole “strong convictions, weakly held” idea. In fact, it’s an integral part of being mentally flexible, which is one of five key character traits of all the greatest traders.

It also keeps our conviction in check.

When filled with a strong sense of humility, knowing we don’t know all the key variables, we tend to operate in a manner more conducive to better outcomes. We manage risk better, size positions better, and are more apt to recognize when we’re wrong, allowing us to quickly become right. As Ray Dalio would say:

You can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.

Here is a sketch of a better way to think about markets.

A Better Way To Think About Markets

A crucial part of thinking in possibilities is defining what inputs (price action, fundamental news, sentiment, etc.) would raise or lower your conviction for each possibility.

Basically, define what’ll convince you that you’re wrong and also what’ll increase your conviction that you’re right.

This is not a one-time process. It’s a continual study that you should be running in the back of your mind. Since the market is fluid and always changing, so should be your conviction levels on what’s possible and likely.

Sounds tough, right?

It is. Like I said at the beginning, our minds are not wired for markets. It takes conscious effort to think this way and we’ll always be limited by the biases we carry; many of which we’re unaware.

And it actually gets even tougher. Not only are there unknown unknowns in markets, but markets are also reflexive.

This means that my thinking about the possibilities and your thinking about the probabilities and Joe Schmoe’s thinking about simple predictions ALL affect the market. This in turn affects our thinking about the possibilities, probabilities, and… you get the picture.

I’m not trying to throw you down the rabbit hole. This is just how markets function.

Reflexivity was put forth by George Soros (though the philosophical origins of it actually stem from Karl Popper).

Here’s the actual way you should think about markets:

The Actual Way You Should Think About Markets

It’s a headache right?

And that’s the point. Thinking about markets is hard if you’re doing it right.

You should always maintain a certain amount of insecurity — the good kind of insecurity that makes you constantly question your assumptions, beliefs, and mental models.

Ed Seykota used to say, “There are old traders and there are bold traders, but there are very few old, bold traders.”

If you want to survive in this game, you need to recognize that you operate with a constant information deficit.

You can never know how large this deficit is. Therefore “prediction” is impossible. And assigning actual “probabilities” is useless.

Everything is only “possible” and everything is always unknowable.

This is why thinking in possibilities and increasing your cognitive flexibility is paramount to your long-term trading survival.

Malcolm Gladwell once retold the following story about George Soros (possibly the most cognitively flexible trader to have played the game).

An old trading partner of Taleb’s, a man named Jean-Manuel Rozan, once spent an entire afternoon arguing about the stock market with Soros. Soros was vehemently bearish, and he had an elaborate theory to explain why, which turned out to be entirely wrong. The stock market boomed. Two years later, Rozan ran into Soros at a tennis tournament. “Do you remember our conversation?” Rozan asked. “I recall it very well,” Soros replied. “I changed my mind, and made an absolute fortune.” He changed his mind!


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Lessons from a Trading Great: Jesse Livermore

“Boy Wonder”, “Boy Plunger” and the “Great Bear of Wall St.” are a few of the monikers Jesse Livermore was known by.

Livermore was immortalized in the trading classic Reminiscences of a Stock Operator by Edwin Lefevre — a book your author has read countless times over the years and still pulls new wisdom from with each revisit.

Reminiscences has stood the test of time because it, more than any other book, explains the fundamental truths that lie at the heart of successful speculation. It’s no doubt a reflection of Livermore’s deep and intimate understanding of this great game.

One of the ironies I’ve learned through years of dissecting the habits and practices of top traders like Livermore is that there is nothing special to what they do. I’m not implying that what they’re able to do isn’t impressive; of course it is. I simply mean that they have no special or secret knowledge or ability that’s unique to them.

Most people start out in this game looking for that “thing”; whether it be a special insight or indicator or strategy or whatever, that will show them how to win. They think if they can just find the secrets to what make the greats great, then they’ll be set. But in reality… if there’s any secret at all, it’s that there is no secret.

All of the important truths that a speculator needs to understand were plainly communicated by Livermore over 75 years ago.

Does that mean you can read Reminiscencesand instantly become a great trader? Well, let me ask you this: can you read the classic Ben Hogan’s Five Lessons on golf and go out and play scratch golf? Of course not! And that’s because both books have all the foundational knowledge you need to succeed but they don’t supply the practice that ingrains the lessons and transforms that knowledge into wisdom.

Here’s how Livermore put it, “The training of a stock trader is like a medical education. The physician has to spend long years learning anatomy, physiology, materia medica and collateral subjects by the dozen. He learns the theory and then proceeds to devote his life to the practice.”

The practice is the hard part. It takes time and a Herculean effort. Blisters and portfolio losses. There are no short-cuts. But practice without knowledge is wasted effort. It’s like trying to run on your hands because nobody ever told you to use your feet.

So with that, here’s the knowledge (with some commentary by me), as given by Livermore many years ago. What you do with it is up to you but I suggest you try running with your feet.

Learn How to Lose

An old broker once said to me: ‘If I am walking along a railroad track and I see a train coming toward me at sixty miles an hour, do I keep on walking on the ties? Friend, I sidestep. And I do not even pat myself on the back for being so wise and prudent.’

To be a great trader you have to be a great loser. Sounds like a contradiction right? Well it isn’t. The fact is, great traders will typically have more losing trades than profitable ones. They’ll spend more time in an equity drawdown than at new highs. Some of this is due to the natural 90/10 distributions of markets (Pareto’s Law), but much of it is actually by design.

Mark Spitznagel wrote in The Dao of Capital that the most valuable lesson he learned from his Chicago trading pit mentor, Everett Klipp, was that “you’ve got to love to lose money.” If you love to take small losses then you’ll never take a large one. That’s important because it’s the large ones that’ll kill ya’.

Humans are naturally averse to losing (obvious statement). Our psychological programming attaches a lot of nonsensical meaning to taking losses in the market. We are evolutionarily wired to be bad emotional traders. The key is to invert this instinctual response and learn to “love to lose”. Livermore talks about this inversion:

Losing money is the least of my troubles. A loss never bothers me after I take it. I forget it overnight. But being wrong — not taking the loss — that is what does damage to the pocketbook and to the soul.

And here’s a simple and yet KEY… KEY fundamental truth to good trading: never add to your losers, sell what shows you a loss, and let run what shows you a profit.

Of all speculative blunders there are few worse than trying to average a losing game. My cotton deal proved it to the hilt a little later. Always sell what shows you a loss and keep what shows you a profit. That was so obviously the wise thing to do and was so well known to me that even now I marvel at myself for doing the reverse.

This lesson was important enough that Paul Tudor Jones had it plastered on the wall right above his desk.


Livermore’s occasional failure to follow this rule is what led to the multiple blowups he experienced throughout his career. He lost when he failed to follow his advice that it’s “foolhardy to make a second trade, if your first trade shows you a loss. Never average losses. Let this thought be written indelibly upon your mind.”

Livermore learned the hard way that our natural instincts must be flipped.

Instead of hoping he must fear and instead of fearing he must hope. He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit.

The Importance of Understanding General Conditions

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.

Not many people realize this, but Livermore was the original “global macro” guy. His “greatest discovery” was the importance of macro — or what he called “general conditions”.

He had the same realization that hedge fund manager Steve Cohen had decades later, which is “that 40 percent of a stock’s price movement is due to the market, 30 percent to the sector, and only 30 percent to the stock itself.”

After Livermore made this discovery he said “I began to think of basic conditions instead of individual stocks. I promoted myself to a higher grade in the hard school of speculation. It was a long and difficult step to take.”

This revelation completely changed the way he approached markets and trading. While everybody was piking around, losing money playing the “stock picking” game, Livermore was studying general conditions. He now understood the simple fundamental truth that you want to be long in a bull market and short in a bear market.

I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, ‘Well, you know this is a bull market!’ he really meant to tell them that the big money was not in the individual fluctuations but in the main movements — that is, not in reading the tape but in sizing up the entire market and its trend.

Disregarding the big swing and trying to jump in and out was fatal to me. Nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study general conditions and not tips or special factors affecting individual stocks.

It’s when Livermore started playing the macro game that he really started making the big money.

I cleared about three million dollars in 1916 by being bullish as long as the bull market lasted and then by being bearish when the bear market started. As I said before, a man does not have to marry one side of the market till death do them part.

But I can tell you after the market began to go my way I felt for the first time in my life that I had allies — the strongest and truest in the world: underlying conditions. They were helping me with all their might. Perhaps they were a trifle slow at times in bringing up the reserves, but they were dependable, provided I did not get too impatient.

General conditions (macro) continue to be — BY FAR — the biggest potential source for alpha in trading. That’s because most market participants are still focused on the stock picking game and remain completely ignorant of the most significant driver of their stock’s price action. Learning to read the underlying conditions is like swinging the trading equivalent of Thor’s Hammer… it makes that much of a difference.

Patience, Psychology and the Dangers of Overtrading

It sounds very easy to say that all you have to do is to watch the tape, establish your resistance points and be ready to trade along the line of least resistance as soon as you have determined it. But in actual practice a man has to guard against many things, and most of all against himself — that is, against human nature.

Livermore understood man’s foibles perhaps better than most. He made and lost multiple fortunes, the size of which, most could hardly fathom. He knew well the fundamental truth that becoming a great trader is as much about self-mastery as it is about market mastery.

Market Wizard Ed Seykota said “I think that if people look deeply enough into their trading patterns, they find that, on balance, including all their goals, they are really getting what they want, even though they may not understand it or want to admit it.”

True professional speculation is often a tedious and boring affair, where one can go months without putting on a trade because the general conditions are not right.

There is a time for all things, but I didn’t know it. And that is precisely what beats so many men in Wall Street who are very far from being in the main sucker class.

Most traders that I see are not really in the game to make money by strictly following a sound trading process. They want quick profits; the thrill of gambling; high adrenaline entertainment. Basically the same lizard brain “wants” that drive the large profits for Vegas casinos.

This is why most people overtrade. And they overtrade a lot. Here’s Livermore’s thoughts on why that’s bad.

There is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall Street fool, who thinks he must trade all the time. No man can always have adequate reasons for buying or selling stocks daily–or sufficient knowledge to make his play an intelligent play.

The overtrading by others brings us to another fundamental truth: that other’s impatience can be our profits if we’re willing to practice infinite patience.

The desire for constant action irrespective of underlying conditions is responsible for many losses on Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages. Remember this: When you are doing nothing, those speculators who feel they must trade day in and day out, are laying the foundation for your next venture. You will reap benefits from their mistakes.

When putting on a trade it’s better to be a little late than a little early. As Livermore put it, “don’t take action with a trade until the market, itself, confirms your opinion. Being a little late in a trade is insurance that your opinion is correct. In other words, don’t be an impatient trader.”

Self-mastery leads to market mastery. Livermore said “the human side of every person is the greatest enemy of the average investor or speculator. Fear keeps you from making as much money as you ought to. Wishful thinking must be banished.”

Price Action and Path of Least Resistance

There is what I call the behavior of a stock, actions that enable you to judge whether or not it is going to proceed in accordance with the precedents that your observation has noted. If a stock doesn’t act right don’t touch it; because, being unable to tell precisely what is wrong, you cannot tell which way it is going. No diagnosis, no prognosis. No prognosis, no profit.

Livermore was one of the best at reading the tape. His years of studying price action gave him a sort of “sixth sense” for knowing what the market was doing and where it was headed. This is one of those “practice” elements where only so much instruction can be given… the rest needs to be learned and experienced.

But one of the important lessons that Livermore talked about is studying price action in order to determine the “path of least resistance”, saying:

For purposes of easy explanation we will say that prices, like everything else, move along the line of least resistance. They will do whatever comes easiest, therefore they will go up if there is less resistance to an advance than to a decline; and vice versa.

The path of least resistance is all about understanding accumulation/distribution or consolidation/expansion zones. A chart is simply a two dimensional representation of supply/demand. The path of least resistance is the price level that supply/demand is likely to move towards based off past and current accumulation/distribution levels.

Learn to read supply and demand action with practice and your trading will become more fluid. Livermore stated, “It would not be so difficult to make money if a trader always stuck to his speculative guns — that is, waited for the line of least resistance to define itself and began buying only when the tape said up or selling only when it said down.”

A critical part to what he’s saying is to wait for the path of least resistance to present itself. Attempting to anticipate trend changes is a costly and foolish endeavor.

One of the most helpful things that anybody can learn is to give up trying to catch the last eighth — or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.

Trend reversals are a process, not an event. Livermore notes “that a market does not culminate in one grand blaze of glory. Neither does it end with a sudden reversal of form. A market can and does often cease to be a bull market long before prices generally begin to break.”

The trend is your friend and there are separate trends on different time intervals. The more trends that line up on each interval, the lesser resistance on the trade’s path.

Big Bets and Sitting Tight

And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight!

Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money.

The average trader is quick to take a profit and slow to book a loss. Going back to the importance of inverting our trading nature, it’s as important to let profits run as it is to cut losses short. Remember, we’ll lose more than we’ll be right. So we need those winners to be significantly larger to pay for our losers. Livermore said, “they say you never grow poor taking profits. No, you don’t. But neither do you grow rich taking a four point profit in a bull market.”

Livermore explained successful trading plainly, “I study because my business is to trade. The moment the tape told me that I was on the right track my business duty was to increase my line. I did. That is all there is to it.”

The fundamental truths of speculation, as laid out by Livermore three quarters of a century ago, can be summarized as follows:

  • Cut your losses: Never average down and never hope losses reverse. Just cut.
  • Infinite patience: Good trades are few and far between. Trade for profits, not for action.
  • Learn macro: Understanding general conditions is essential to being a market master and not a piker.
  • Price action is king: Learn to read the tape and don’t argue with markets — they know more than you.
  • Big bet/sit tight: Ride your winners for all their worth. This conviction comes with practice.
  • Self-mastery: You are your greatest impediment to your own success. “Know thyself”.

These lessons are as true today as they were then. As Livermore put it, “there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”

One just needs to look to Stanley Druckenmiller — perhaps the closest modern day equivalent to Jesse Livermore — to see that these truths still hold true. Here’s Druck:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

Livermore said that “A man can have great mathematical ability and an unusual power of accurate observation

and yet fail in speculation unless he also possesses the experience and the memory. And then, like the physician who keeps up with the advances of science, the wise trader never ceases to study general conditions, to keep track of developments everywhere that are likely to affect or influence the course of the various markets.”

If you’d like to stop piking around and follow in Livermore’s footsteps by learning how to read general conditions (macro), then click here.