Meaning arises out of the situation. Ironically, a German mathematician turned logician and philosopher, known as Gottlob Frege, deserves the original credits for noticing that essentially nothing means anything in isolation. History credits him with the “context principle” but even more ironically, at least to me, is that reportedly, he first articulated this in a book entitled, The Foundations of Arithmetic, which apparently was largely ignored by the intelligentsia of the day. He focused specifically on the subject of words, which while that might seem limiting, in fact, barely limits the concept at all given that we ultimately think in words.
In practicality, facts have no meaning without context. The intertwined circumstances in which events occur make literally all the difference in knowing what any one “something,” even a market “fact,” actually implies.
Think about it. Does any given market level, in any market (stocks, bonds, gold, oil) mean anything on its own? If you knew nothing else about the markets other than the Dow was trading at 10,000, would it mean anything to you? How would you know if that were a good thing or bad thing? Would you even know if it revealed bull- or bear-like behavior?
Suppose you make your living painting. You have spent your whole life drawing, coloring, visiting art supply stores, and dreaming of (or actually) strolling the streets of Paris. What are the odds that you would be able to come up with much of any meaning at all for any Dow level? Let’s even suppose that of course you have seen CNN so you know that when you see the word Dow, it refers to something having to do with the US financial markets. But would you attach much significance to yet another trip through 10,000? Well, you might, if you understand that when the market goes up, the value of art goes up and when the market goes down … well, there is always Starbucks.
We tend to overlook the fact that Dow 10,000, or even Dow 15,000, means nothing without knowledge and at least some modicum of understanding of what came before. In order to interpret, you need to know if the backstory emerges from a place at Dow 8,000 or 20,000. Take what is going on in the market today. We have had a downward slide into today, into August, but how do we judge whether it will it turn into a rout like 2007 or will it be like 2010 when we had a 20% correction only to come roaring back?
On the other hand, if you also know the history of market levels, you have the framework you need for 10,000 to mean something. Today, as we sit here in this classroom, we know that would be a very bearish number to hit. So at a minimum, you know whether that is higher or lower and, depending on your orientation, a long-only kind of trader or a perma-bear short-selling fund, you don’t have to do much thinking to know whether you like or don’t like the number and whether, at the moment, it means you are making or losing money.
In 2005, Ming Hsu, who now heads the neuroeconomics lab at University of California, Berkeley, published (with his colleagues) a piece of pivotal research that looked into what the brain does when it comes face to face with a traditionally defined risky situation (where the probabilities are known) versus the ambiguous scenarios (where historical probabilities provide only a clue).
Classic decision theory assumes the brain handles both in the same way; but Hsu wasn’t so sure and, indeed, they found differences in the route the blood takes through the brain, depending on the type of problem at hand. Hsu proffered the idea of an “uncertainty circuit” or the idea that a sort of red flag went up saying “more information needed.”
Now this might sound innocuous or obvious enough, but if you take maybe the second most repeated rule of trading—“plan the trade and trade the plan,” Dr. Hsu’s research sheds a lot of light on why, no matter what anyone says, traders of all types find this so incredibly hard to do day in and day out, trade in and trade out. This supposed truism assumes a computer model of thinking. In practicality, it leaves very little room for context and certainly none for a warning flag that more information must be obtained.
Traders try to do exactly what they planned while their brain fights them to find more information or to scramble in the face of a clear, but maybe only subconsciously perceived, threat. I used to use the analogy of a jungle versus algebra, but now so many people have taken that statement and made it their own that I want to put it another way.
Your brain automatically and immediately understands the difference between counting out change at Starbucks and leading a football team, and you cannot fool it into thinking or reacting as if the latter is the former.
Whether you are a goalkeeper in European football or a quarterback in the NFL, you know your game plan only gives you a framework. If you see another player headed straight for you, you are going to make a split-second decision to get out of the way, get rid of, or protect the ball—no matter how many hours went into a plan “dictating” your actions.
Give it up—you can’t force the uncertainty of an ever-evolving athletic contest into a formula that must be followed at all costs. Or, at least you can’t, if you want to have any chance of winning the game!
Michael raised his hand. “Doesn’t it seem as if traders generally don’t appreciate how much their craft resembles sports? I mean, what you are saying is that the data only goes so far and then you have to put current factors together to make a judgment call, right? And really more importantly, if I am understanding this research, is that our brains are going to call up a judgment call play whether we like it or not, right?”
Yes, that is it exactly. In fact, shortly after the Hsu team’s “uncertainty circuit” idea hit the academic streets, a group at Duke University led by Scott Huettel took a slightly different direction and showed that depending on whether you are flipping coins, working the equation 2y=6–4, or deciding about buying GE stock, your brain will engage “distinct mechanisms.” In the words of this study, “something special” occurs in the midst of ambiguous incoming information and that something is analysis of context!
For example, in a game of dice, you don’t need very much context to know the odds of getting a 6 on any one roll of any one well-built die (six evenly sized square faces)—1 out of 6 right? You have all the information you need to make a pure probability bet. When faced with a market question, however, you have at minimum incomplete information and most often conflicting data that must be interpreted. Even worse, you aren’t interpreting to solve for Y but to properly gauge the future perceptions of other market players who will buy when you want to sell or vice versa. How do you decide what they will likely think? Or more importantly, when they will think it?
According to Huettel, our brains go into what I like to think of as “jigsaw puzzle” mode. You look at the shapes and colors that seem to match and indeed you actually find them, even though they are simultaneously very different and very much alike. When these numerous possibilities present themselves, the brain mixes and matches until a given scenario seems to fit better than the next. It assembles a working context or set of set of perceived relevant factors from both what is known and what is predicted.
In uncertainty, we rumble through different possible pattern matches and choose which factors we believe and more or less how we rank each factor. These researchers say we actually mentally create fresh contexts built on the pieces and parts of prior knowledge.
So when you think about whether or not to sell AAPL, should you outright exit at $400 because everyone who wants an iPad has one or should you move a stop-loss order to protect against giving money back? The “context-creator” goes to work to assemble what seems to you as the most plausible and likely scenario.
Unfortunately, markets, at least for the average trader, don’t supply the immediate right/wrong feedback of a jigsaw puzzle, which often frustratingly leaves us stuck in never-ending wonderment over whether whatever decision about the “risk” we took, is, was, or will be the right one. We will get to the ever-present “fear of missing out” that comes into the contextual play here, but first I want to underscore the importance of these first glimpses into part of the brain’s uncertainty processing.
The Duke team showed, at least in their experiments, that a critical node in the brain’s scenario, the posterior inferior frontal sulcus (or pIFS for short) apparently thrives on uncertainty. It lights up with oxygen flowing through it like a Christmas tree when you flip the switch. It lies beneath the temples, and it strikes me as possibly a non-coincidence that many of us, when “thinking hard,” feel compelled to massage our temples. Checking Google for “rub your temples” in fact yields pages and pages of how it helps headaches, serves as an acupressure point, and is used in yoga. Theoretically, you could extrapolate that the massage increases blood flow, as massage does, and in turn sends even more oxygen to the part of the brain which needs it most! More ironically, this pIFS evidently works faster than other nodes more associated with known probabilities.
Counterintuitively, we deal with uncertainty faster than we deal with arithmetic! Could this be because the vast majority of what we deal with is actually uncertain even though we typically forget that in reality we don’t ever know what will happen tomorrow.
Whether we talk markets or life, instead of uncertainty being the exception, it is the rule. Known precision is the exception and, as such, it appears to take more time to hand off this relatively special circumstance to some odd part of the brain that deals in linear, serial, and exact questions. Maybe the broadcast of the glia cells simply works faster than the electrical network of the neurons—it seems conceptually at least plausible.
Beyond the neuroscience however the point remains: you gain psychological leverage when you make a set of contexts explicit with an intentional focus on the “meaning gap” between where numbers leave off and good judgment begins. In practical terms, resolve to know your contexts—all of them.