Ideas From A Psychologist

I receive got merely finished reading Daniel Kahneman's bestseller "Thinking, Fast as well as Slow", as well as establish it sum of inspirations of import for traders. This is no surprise, of course, since Kahneman won the 2002 Nobel prize inward economic science for his function on determination theory. Here are unopen to of the notables:

1) Simple pith is oft improve than a linear regression fit. Remember my constant mantra that "simpler is better" when edifice trading models? I receive got e'er advocated linear regression over nonlinear models, but Kahneman went a pace further. He said that inward social scientific discipline modeling (which of flat includes fiscal markets modeling), assigning equal weights to the predictive factors is oft superior to weighting them using multivariate linear regressors when applied to out-of-sample data.

2) Overconfidence inward corporate acquisitions. Managers of acquiring companies oft believe that they are improve than the managers of acquirees. This overconfidence has several causes: in that location is an illusion of command which overemphasizes the component subdivision of science as well as neglects the component subdivision of luck, as well as in that location is a focus on what 1 knows as well as a fail of what 1 does not, etc. The marketplace seat already knows this: the stock of the acquirer normally suffers a sell-off upon proclamation of the acquisition, because the upshot of whatsoever acquisition is to a greater extent than oft bad than good, but the query is whether it has sufficiently discounted this phenomenon. Would shorting the stock of an acquirer at the completion of an acquisition as well as asset the brusk seat for, say, v years, hedging this seat alongside SPY, move profitable?

3) Premortem. After designing a trading strategy, it is e'er useful to write a brief imaginary history of how it has cash inward one's chips an unmitigated fiscal disaster for yous a few years from now. This volition probable break scenarios that yous receive got non previously idea of, as well as triggering additional direct a opportunity administration measures.

4) Risk seeking inward the aspect upwards of losses. Suppose yous are running a strategy that has a fixed asset period. Have yous ever extended this asset catamenia when the seat is losing, inward the promise that the seat volition recoup unopen to of its losses? I have, as well as the upshot was double the loss I would receive got suffered had I exited on time. Apparently this is a rattling mutual suboptimal behavioral bias: this is why many defendants alongside a weak legal illustration oft direct a opportunity continued litigations instead of accepting an unfavorable settlement.

5) Why create nosotros oft need Sharpe ratio  >=2? Psychological experiments receive got shown that people discovery the hurting of losing $1 tin plough over the axe entirely move compensated past times the pleasance of winning $2. So if nosotros equate criterion difference equally the average drawdown of a strategy, hence nosotros require to receive got twice the average return!

Many businesses receive got profited from arbitraging the difference betwixt rational decisions as well as biased decisions that people commonly made. (For e.g. lottery franchises create goodness from people overweighting the probability of winning, sellers of extended warranties create goodness from buyers' risk-aversion.) I wonder if in that location are still opportunities left for rational traders to convey payoff of the biased decisions of irrational traders?