I first saw a reference to Michael Shermer’s book Why People Believe Weird Things in David Aronson’s Evidence-Based Technical Analysis. The Shermer book isn’t particularly revelatory; in fact, today’s takeaway comes not from Shermer himself but from a 1981 study by Singer and Abell that he cites. Again, not groundbreaking, but worth repeating.
When people are asked to select the right answer to a problem after a series of guesses and positive or negative feedback from the investigator, they regularly fall into dangerous traps. First, they form a hypothesis and look only for confirmation of the hypothesis, not for evidence to disprove it. Second, they are very slow to change the hypothesis even when it’s obviously wrong. Third, in the face of complex data, they adopt overly-simple hypotheses or strategies to solve the problem. Finally, they always find causality, even if the investigator’s “right or wrong” feedback was given randomly.
Traders and investors fall into the same problem-solving traps as the rest of the population but they often pay a higher price. Perhaps it would be time to have a checklist to accompany each investing or trading hypothesis. (1) What would qualify as evidence against this hypothesis? (2) When should I throw in the towel? (3) Is my strategy adequate to the problem? With certain kinds of investments and trades you might add: (4) Am I mistaking correlation for causality?
The checklist won’t guarantee profits, but it might dampen losses.