One of the things I value most about the work of Nassim Taleb, is how he manages to convey seemingly complex ideas with simple examples in his trademark conversational style. What follows is the second such example we have taken from his book Fooled By Randomness: The Hidden Role of Chance in Life and in the Markets, which I highly recommend to all traders, whether you're a budding neophyte or a seasoned veteran.
This example centres around the timescale you use to monitor your investments and how it largely determines how much signal versus noise you receive. In other words, how much meaningful information you are able to extract, compared to just observing the variance of your investment/portfolio.
To convey his message he creates a fictional happily retired dentist. The choice of occupation here is not accidental as elsewhere in the book he uses the career path of dentistry to embody a collection of life choices and values that include studiousness, hard work and patience. So right off the bat we have an individual who we may think of as rational, conservative and perhaps even a touch risk-averse.
We are told that our dentist is an accomplished investor, who manages to earn 15% in excess of US Treasury Bills per annum, with around 10% volatility. Taking into account that 68% of all observations will fall between -1 and 1 standard deviation, we can expect that 68% of the time his returns will be between 5% and 25% (15% expected excess returns plus or minus 10% expected volatility). If we look at 2 standard deviations, which will account for 95% of all observations, we can expect his portfolio to generate returns of between -5% and 35% (15% +/- 20%). In any given year this translates to a 93% chance of profitability for our retired dentist. Not bad, as I'm sure you'd agree.
Now here's our problem. Our dentist subscribes to an online service that supplies him with the real time prices on the instruments he trades. So now, at the click of a button, he can view how much his portfolio is up or down whenever he pleases. Here's what the dentist isn't aware of:
While his portfolio has a 93% chance of profitability per year, this drops to 77% per quarter, 67% per month, 54% per day, 51.3% per hour, 50.17% per minute and 50.02% per second. The shorter the time frame, the higher the effects of randomness, nothing new here. But the real issue is that now our retired dentist must contend with the emotional roller-coaster that is his portfolio's variance. Unable to resist the urge to constantly check how his investments are doing, he is now inundated with a great deal of useless information that only serves to confuse him and make him question an otherwise sound investment strategy. For every perceived loss he becomes stressed, for every perceived gain his mood improves and back again.
Taleb, never one to shy away from hammering a point home, proceeds to explain that for every eight hours of monitoring his investments, our retired dentist will experience 241 pleasurable minutes versus 239 unpleasant ones, or 60,688 pleasurable minutes per year versus 60,271 unpleasant ones. All this with a strategy that is essentially foolproof.
Daniel Kahneman and Amos Tversky demonstrated in their pioneering work on decision under risk (more on these guys in another article), much to the chagrin of conventional economists, that human beings are not as rational as we like to think we are when it comes to weighing potential losses and gains. In fact, it is more likely that we will take on risk in order to avoid a loss than to secure a gain. Just this should tell you all you need to know about what Taleb is getting at with his story of the happily retired dentist. But to take the point even further, a study conducted by Gehring and Willoughby in 2002, in which they hooked up their subjects to an electroencephalogram (EEG) while getting them to perform certain gambling tasks, demonstrated that we actually feel losses more intensely than gains.
'A negative-polarity event-related brain potential… was greater in amplitude when a participant's choice between two alternatives resulted in a loss than when it resulted in a gain… gains did not elicit the medial-frontal activity when the alternative choice would have yielded a greater gain, and losses elicited activity even when the alternative choice would have yielded a greater loss. Choices made after losses were riskier and were associated with greater loss-related activity than choices made after gains' (Gehring and Willoughby, 2002).
The Gehring and Willoughby study confirms what behavioural economists have believed for decades. However, the main difference between Taleb's retired dentist and you, is that Taleb makes no mention of the dentist altering his trading strategy based on the negative feedback he receives upon checking his portfolio's performance more often. How many times have you changed your approach mid-trade? And how many times was this change elicited by some temporary market move that you wouldn't have even noticed if you were checking your trades less frequently? The moral of the story is that the narrower the time frame at which you're monitoring your chosen instrument, the greater the degree of randomness in the price fluctuations you're witnessing, which means you will invariably receive negative feedback much more often and are far more likely to change your strategy or exit trades that may have been sound all along.