Why People Feel Good About 80% Losses (And How To Avoid That)
Lesson 6 | The Absolute Beginner’s Guide
The human mind is predictably irrational. To give you a sense of what I mean, just answer this question. Would you rather:
- A) Get a broken leg,
- B) Hurt your knee so that it ached when the weather got rainy for the next year.
Even if we assume that option (A) hurts more, the strange thing about our brains is that they have a psychological immune system. We’ll re-adjust our expectations about what we can do with a broken leg—no soccer practice or jogging, for example. But with (B) we’ll not adjust and, as a result, just be continually irritated.
Psychologists have found that (A) is the more tolerable result (read Dan Gilbert’s Stumbling on Happiness for more such studies).
A version of this kind of irrational reasoning is at work with people who have steep losses (80%+) in the market. They are supported in their view by a way of trading that is just as popular as it is unhelpful. That “method” is called chart reading.
My goal is to explain what it is, why it doesn’t work, and why people are drawn to it.
If avoiding mistakes could have a dollar value, then this lesson might deliver the biggest bang for your buck of the entire Absolute Beginner’s Guide.
To put it in perspective, consider this. Suppose that you stumbled across a magical lamp with a greedy, but helpful genie. For freeing him, he offers to help you avoid just 10% of your trading errors throughout the course of your life. How much would you be willing to pay?
Would it be more than the annual cost of a subscription to this newsletter? I’m guessing so.
As a topic, chart reading has come up on our Discord server. The reason is that people turn to its method when their trades don’t go as expected. We’ve gone over better strategies there and you can join us for daily chats for free.
To be precise, chart reading is one part of what is often called “technical analysis.” Technical analysis is an unfortunate grab-bag of techniques, some of which are genuinely useful and others of which are no better than trading based on astrology. It includes, to my mind, three main ideas:
- Chart Reading
- Precedent Reading
- Momentum Analysis
A discussion of momentum analysis and the hundreds of academic articles that support its superior performance to other strategies is the substance of Lesson #7 in the Absolute Beginner’s Guide (and it’s already written).
This lesson is going to explain what is both alluring and problematic about the first two dimensions of technical analysis. Let’s start with some images.
Patterns in Price Movements
Here’s an example of chart reading taken from Investopedia (obviously). It’s called the Head and Shoulders pattern.
The idea is that when you see a formation of price movement that looks like this, it’s bad news for the stock price.
Here’s another, called the cup and handle.
When you see this formation, it’s considered a bullish signal, meaning that the price will go higher.
These are fun to spot—a bit like seeing patterns in clouds, or fortune-telling by reading tea leaves or palm reading.
My wife, whose PhD covers human cognition, likes to read people’s palms at parties. She’s always a big hit.
But we don’t invest using her palm reading techniques and neither do we invest using technical charts.
A little better notion than chart reading is precedent reading, which is based on resistance and support. Here’s an image of a support line for a stock (again from Investopedia).
The idea is that there is support for the stock at that $51.25 price range because it hasn’t fallen below it before.
Here’s an image of resistance.
The idea here is that the stock has a hard time going above $39 because it’s failed to break out above it so many times.
What’s wrong with these strategies can be illustrated with a story.
Jason’s Dr Pepper Story
Jason is my collaborator in the YouTube series we’re putting together on these lessons. It’s a Pod-Cast styled chat with screen captures, illustrations, and experiments to help people learn.
Like me, Jason also majored in philosophy as an undergraduate student. So, he studied logic and knows about what makes for good scientific theories.
He jokes that drinking Dr Pepper makes you taller.
If you find a person who drinks a lot of Dr Pepper and is short, he’ll say: “Well, they would have been shorter.” If you find a person who doesn’t drink any Dr Pepper and is tall, he’ll say: “Well, they would have been taller.”
As a result, there is literally no factual condition that could dis-prove his “theory” that drinking Dr Pepper makes you taller.
In philosophical terminology, his “theory” is non-falsifiable.
The problem with non-falsifiable theories is that they don’t actually tell you anything. Because they can’t possibly be wrong, they hold a logical status like the following claim: “either it will rain tomorrow or it won’t.” Of course, that’s true, but it doesn’t tell me whether to bring an umbrella for a trip.
Such “theories” secure invulnerability at the price of being empty. And if you have a vacuous strategy, then it literally can’t tell you how to trade.
Now, I need to show you how chart and precedent reading fall into this trap.
How Chart and Precedent Reading Are Non-Falsifiable
Look at the following chart of Bitcoin’s price action. Can you see the head and shoulder’s formation?
Well, just like the chart theory said, a head and shoulders formation is bad and Bitcoin plunged afterwards. So, true theory right?
No. That’s confirmation bias. Have a closer look.
Do we have two heads here? Like a tiny head and a large one? And how many shoulders are there exactly? It looks like two left shoulders at least.
The moral is simple: chart reading is too ambiguous to be rigorously testable.
People have similarly wanted to use resistance and support analysis to understand Bitcoin’s bottom. Here’s how that might look.
While those are previous resistance/support levels, I challenge you to show me how this is any more informative than claiming: “either it will rain or it won’t.”
Reading the precedent, the chart says that Bitcoin will fall to just under $50k, and if not that, then just above $45k, and if not that, then just under $40k and if not that, then $33k …
So, what’s the ultimate bottom?!
At some point, Bitcoin will hit some previous year’s level of resistance, making it “true.” But this isn’t a kind of truth that is informative, which leaves us with an obvious question.
Why Do People Use This?
As a professor of logic, I’ve been fascinated by why people, myself included, fall into irrational patterns of behavior. We do it a lot.
Fortunately, the field of behavioural rationality—which spans philosophy, economics, psychology and other social sciences—has made some pretty significant advances.
In Thinking: Fast and Slow, the Nobel laureate Daniel Kahneman points out that our brains try to conserve energy. Often, they do this by substituting an easier task for a harder one. Think, for a moment, about the following question.
- Are there more words that start with “R” in English or that have “R” in the third position—as in “three”?
Most people get this wrong. There are vastly more words with “R” in the third position than words that start with “R.” The reason people get it wrong is that it’s much easier to think of words that start with “R” than those with “R” in the third position.
You go: “railroad,” “roadmap,” “rooster” … and then compare that with “for,” “fork,” “forward”… those come, but they are hard.
What you and I (and everyone) does is substitute the easier task of recalling words for the hard task of actually looking up the answer.
The same thing happens with chart analysis.
It’s a lot easier to look at a chart and see two points of “resistance” and conclude, “oh, $30,000 is the bottom,” than it is to do a statistically significant historical analysis of all of Bitcoin’s price movements.
So, people have an immediate emotional fear and go for the quickest and easiest answer that will satisfy their fears. This, in brief, is why people make poor trading decisions.
Why do people feel good while losing 80% of their trade?
What the above suggests is they gain a false sense of control over that 80% loss by looking to a chart pattern that tells them “the bottom is in.” By doing this they exchange a short term sense of control for a longer-term satisfaction at having made a good trade.
Resistance analysis on its own will lead you to hold Bitcoin until, ultimately, it drops to the statistically significant range of about an 80%-90% price decline in a crash. In that whole process, you might feel in control, but you won’t earn money.
So don’t use it.
Instead, just recognize that hard work is needed to answer questions like: how far will Bitcoin fall? And then you need to be prepared for caveats like, “if the future follows the past roughly.”
In sum, chart analysis is too prone to ambiguous answers ever to be more than reading tea leaves. Resistance is only meaningful with a statistically significant sample–as a rule of thumb, at least 30 incidents. Anything less is no better than Jason’s Dr Pepper “theory.”
The next lesson focuses on what does work: momentum trading.
For those of you wondering what to do in a crypto-winter, we’re discussing staking opportunities to get 7% – 100% APR on Discord.
Today is a holiday in the US, so as a note to all my Paid Subscribers, you’ll get your Newsletters on Tuesday!
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