The Outcome Bias

Readers of "A Dash" know that we are not attempting to describe or explain every zig and zag of the market.  It is not that we lack opinions; it is just not our purpose.  By way of contrast, each day we write a market commentary for our clients on our private blog.  For our investors, we discuss what is currently happening with special attention to the positions we own.

Background:  Explaining the Daily Market

This daily exercise puts us in the position of the journalist, looking at the blank page and needing to write something intelligent to describe market action.  The journalist has no choice.  Something must be written.  Tomorrow’s readers need an definitive explanation.

We have a choice.  We frequently observe that market moves were basically random noise.  Often we disagree with what we know will be the headline story in the next day’s papers.  [For today — Oil prices went up, despite OPEC supply increases.  There was a lot of
futures buying driving a low-volume rally.  Some big player(s) wanted
more exposure.  There is no real explanation.  Others will cite a "rethinking" of Fed moves.  Yada, yada.]

The Outcome Bias

One of the many useful contributions of the study of cognitive biases is the outcome bias.  When one starts with knowledge of the result, it is easy to find explanations and easier to conclude that one’s own decisions would have been perfect.  There are strong psychological studies of this effect.

My non-trader friends often observe, after a volatile market day, how wonderful it must have been for traders.  It shows how little they understand.  The volatile day provides potential for a wide variation in results.  It all depends on how one was positioned going in.  For those with each position there will be successes and failures.

Long Premium.  This means that you own options which gain deltas (your favorable position gets bigger) as the underlying stocks move higher and lose deltas as the stocks move lower.  The trader takes "scalps" by selling short stock on the rally and buying it on the decline.  Even this trader may kick himself for "selling too soon" or not guessing the trading range correctly.  The actual traders with this position will do many different things, some getting the optimum result by selling at the top.  Others might wind up losers if they do not trade at all, expecting a big run rather than a trading range.

Long the Underlying.  Your stock (or index) rallies.  You get a big upward move.  Did you sell anything?  If you did, you can buy back lower.  If not, you have some explaining to do, since experienced traders always sell something into rallies.

Short the Underlying.  Your stock (or index) rallies in your face.  Your losses are mounting.  Do you throw in the towel?  Do you add to positions?  Either could be correct, but today, only one decision was right.  As in the other cases, some of those with this position make each decision.  There are many different stories, including those selling at the top.  Every trade has two sides.

Short the Premium. This is the toughest.  Suppose that a trader decided after last Friday’s employment report to sell some index calls, expecting them to expire worthless.  A big rally like today’s can cause calls to explode in value, making the position much larger than the  original planned size.  Should the trader bail out?  We know from experience that every trader has a price where he gives up.  If the trader does not have this price, his backer or clearing firm does.  Brett Steenbarger has a great discussion of trader fear, and this is one of the causes.  [searching for Adam Warner’s recent great article on this topic.  UPDATE: Link added.]  Our experience with traders is that original position size is often too large, based upon what the trader hopes to gain, rather than the risk of loss.

An Experiment

In tournament bridge circles (a group including many leading traders and investors) we often give a problem "on a napkin."  It is called this because it involves card play, and is written down at dinner on a handy piece of paper.  Sometimes there is an obvious way to play the hand — clearly best via expert analysis.  The person posing the problem hopes to get confirmation for his (losing) decision or admiration for his brilliancy from his fellow experts.  The problem is that some of those getting the problem may try (consciously or subconsciously) to gain acclaim from dinner companions by finding the winning answer on the particular deal.  That respondent may choose an anti-percentage action, just because of the problem setting.

This would be an interesting trader experiment.  We are not going to summarize the factors leading to today’s trading, since the information is readily available.  Instead, let us imagine an experiment.  Perhaps Brett Steenbarger, who works daily with traders, or Scott Rothbort, who uses innovative methods in his classes, will give this experiment some thought and find an implementation.

Take a day like today, and some other big market moves.  Provide whatever information might seem to be relevant — charts, economic fundamentals, earnings stories, breaking news — to everyone in the test panel.

Tell them the news —  in advance!

Each participant gets to predict the market outcome knowing the news in advance.  The experiment could include a variety of situational examples with different facts.

The key point is one of our recurring themes — the difficulty in predicting unlikely events.

We would expect a range of outcomes with very few coming close to maximizing the result.  We suspect that those with the "wrong" positions would do the worst, reacting to fear.  Those with the "right" positions would not come close to optimizing the result.  This expectation is based upon experience.  We have been there.

Individual investors who understand the advantage of staying with the normal odds — and not trying to predict extreme outcomes — can gain a significant advantage.  For the individual investor it comes down to understanding the difference in time frames and not being frightened by volatility.

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  • Barry Ritholtz September 12, 2007  

    You have hit on a key element that many investors have trouble with: They focus on the results and not the process.
    As fund of funds proliferate, and hedge funds are now asked about their WEEKLY performance, this issue is only going to become more significant — even amongst the so-called pros.
    Anyone who has ever dealt with retail brokers or their clients for an extended period of time (as I have) knows all about the Halo effect, the hot hand, and all sorts of other myths.
    Until investors focus on their process, they are doomed to fear, inconsistency, and underperformance . . .

  • adam September 12, 2007  

    hey Jeff, I’d be glad to help, lol.
    I think you were referring to this though I’m not positive.
    Thanks either way.

  • Bill aka NO DooDahs! September 12, 2007  

    But a long history of poor results (in managing money or in making economic predictions) does indicate a problem with process.

  • Barry Ritholtz September 13, 2007  

    Then you should change your process . . .

  • Bill aka NO DooDahs! September 14, 2007  

    ROFLMAO! Physician, heal thyself!
    One of the first things I do to examine a writer’s or commentator’s process is look to see where they stood at turning points in the economy, and whether they have been consistently wrong in calling for recessions and stock market collapses. When I see someone that has predicted 4 or 5 of the last 0 stock market collapses, I say to myself, “There’s a man with a c#@%%y set of processes.”
    Keeping with Dash’s “predicting rare events” theme, since recessions happen about once every five years, the accuracy standard to be measured against isn’t 50% accuracy – it’s 80% accuracy. One can hit 80% by saying “no recession” each and every year. Should I research anyone’s accuracy on that regard?