Making Sense Of The Markets

When a person decides to enter the financial markets and learn to trade, they bring years of personal experiences with them. Those experiences are usually a detriment to profiting as they are based on one's life experiences. The financial markets, as well as all freely traded markets from stocks to commodities, from currencies to tulips, behave in a much different manner.

Typically, when we first learn how to trade, we study the markets and try to develop our own personal theories about how the markets work. Because we don't actually conduct formal experiments though, we fall prey to psychological biases. Those same personal experiences, built over a lifetime, which helped us to advance and learn in our world, wind up being the very reason most traders fail to profit.

False Consensus Effect

One of these psychological biases is the false consensus effect... we tend to wrongly think that others believe what we believe and do what we will do, but that's only our perspective and it can mislead us.

Why is it difficult to anticipate what people will do? Part of the problem lies in the fact that we are mere mortals. Humans have a limited capacity for understanding complex information. In some ways, people can process information better than a computer, but in other ways they cannot.

The false consensus effect is one of those rules of thumb that may bias our decisions. No matter what decision you ask people to make, no matter how important the issue, and no matter what choice is made, social psychologists have demonstrated that people over-estimate the number of others who agree with them.

There is a natural tendency to believe that our decisions are relatively normal, appropriate and similar to what our colleagues and peers would do in a similar situation.

We use our decisions as an "anchor" and evaluate what others would do based on what we would do. Decisions based on "our" life's experiences. Our biases. Our interpretation of events and their consequences.

This decision-making bias can contribute to feelings of over-confidence. Once we make a decision, we tend to be confident that we are correct and that others will agree with us, but had we seen the situations from their perspective, we may see that they would behave quite differently.

Anticipating What The Masses Will Do

Market timing is often about anticipating what the masses will do. Will they buy or will they sell? It can be hard to do.

Take the past several weeks, for example. With the war, the hurricane(s), and high oil prices, one might think that the masses would bail out of the markets.

But instead, for several weeks during and after hurricane Katrina, the markets rallied. Now, faced with another huge hurricane (Rita), aimed again at the Gulf coast and all those oil rigs, the markets quickly declined. Same threat but two very different reactions to them.

It goes to show that you can't always anticipate precisely how people will react to world events. It's all a matter of having the right perspective, and it can be hard to find that perspective at times.

The Very Best Timing Strategies

The very best timing strategies have losses. The reason for this is that the markets can not be predicted with certainty. Sure, someone will make a good call and get lots of publicity, but consistent correct predictions just do not happen.

It is the same with trading reversals. There is always someone who predicts and perfectly catches a market reversal. But try and do it consistently and you will quickly see your savings decline.

So, when times like these occur, where the markets move up and down with extreme volatility and with no apparent trend, you need to sit down and recognize this for what it is.... a time when no strategy will be able to make all of the calls correctly.

Unless History Has Forever Been Changed

But remember... and we wrote about this only a few weeks ago... without following any strategy, you have chaos. You will lose money.

Following a carefully defined "strategy" is the only sure way to be certain we will be in the right position, at the right time, when the markets take off in one direction, and stay in that direction.

Unless history has forever been changed, a trend is in the near future. It is critical that we be onboard it to profit. The only way to ensure that we are, is to follow the strategy.