In praise of System 1.

 

If you have read my blogs even intermittently, you have a vague idea about who Daniel kahneman is and what is system 1 and system 2.
Now all along, the underlying conclusion has been that System 1 is the root cause of problems and shit happens when we end up using System 1 where a detailed, slow and thorough analysis was required. Let us have a look at an example.

 

 

If a weed in the pond doubles every day and it takes 48 days for it to totally engulf the pond, how many days would it take for it to engulf half of the pond.

 

 

Well, if you answered 24, you used System 01 and got trapped in the short cut.

Now is System 01 such a bad thing. I mean in the defense we have only heard statements like there is limited circuitry that a brain has, it cannot sustain by giving bandwidth to every nuance of its existence and so it is bound to create short cuts to ease its life.

However there is more to just that. System 1 is actually the root of all creativity and artistry. System 1 can read patterns that System 2 with all its logic, reasoning and arithmetic genius cannot even fathom.

A computer cannot draw like a Picasso.

So for example, a computer can back-test a system and tell you its risk reward, sharpe ratio and all the arithmetic behind it but it cannot be a George Soros or a Warren Buffet who look for anomalies and patterns in the investment world.

Warren Buffet said the same thing when he was asked about Black Scholes model. He said, surely the maths is right 99% of the time, but fails BIG on that 1%. We as fund managers put a claim that there are exact tell tales and patterns to recognize that 1 % and bet big when you find it.

And therefore he says black scholes can be played by savvy investors (LEAPS), and that is precisely what Cornwall capital did in sub-prime crises and even before that if you read their story in Jack Schwager’s 2012 book. (50% CAGR)

I have a momentum based system which is impossible to code due to discretionary nature of decision making however just because it cannot be coded, doesn’t mean it ain’t profitable.

 

You see predictive models have an inherent flaw. The flaw is also called “LUDIC FALLACY’. 

 

Broadly speaking it says that
• It is impossible to be in possession of the entirety of available information
• Small unknown variations in the data could have a huge impact.
• Theories/models based on empirical data are claimed to be flawed as they may not be able predict events which are previously unobserved, but have tremendous impact.

 

Even the trades within predictive model has so much randomness and chance of luck that 01 or 02 really good or really bad trades or misses can change the entire complexion of the result on its head.

For e.x you miss a 10 bagger opportunity because when the buy signal came, your system was already 100% deployed.

 

So what does that mean, you ignore statistics and don’t back-test your strategy.

 

Hell No. That is NOT WHAT I AM SUGGESTING.

 

All I am saying is that like all other things in life, the middle path is the way 2 success. The swing of the pendulum in extremes is inhabited by the crazy heads. Be it religion, politics, stocks or life in general.

On one extreme, you would come across religious idiots who would go to temple 8 times a day, practice abstinence, get entrapped into superstition, follow a million rules and babas AND on other end you have Atheists.

The middle path is to follow the path without worshiping the finger that is pointing towards it, practicing faith with reason.

Similarly in Stock markets, at one extreme we have people burning their hard earned money based on tips received from TV charlatans with no skin in the game, no accountability, no back test, no risk management and no edge in what they do. AND on the other extreme, we have over leveraged mathematical geniuses suffering from Physics envy, picking up pennies in front of a steam roller with a performance graph of a thanksgiving turkey.

 

The middle path ladies and gentlemen is to ensure that there is a definite edge in what you are doing (System 02 analyses of risk reward, back tests, historical evidence, drawdowns, risk management, risk of ruin) and enough leeway to accommodate System 01 ‘insights’ like pattern recognition and a feel. For example immeasurable things like first generation entrepreneur with fire in the belly.

 

As baba Einstein rightly said,
Not everything that counts can be counted, and not everything that can be counted counts.

 

Bottom line is that it is rather stupid to ignore System 1 Pattern recognition just because of lack of statistical evidence. As Taleb puts it, absence of evidence is NOT evidence of absence”  

2 thoughts on “The middle path.

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