Are you an Informed Trader?

I recently finished reading a book called The Perfect Swarm by Len Fisher.   After reading at least 150 books on the market, I now like to read books on a more diverse range of topics, but I often find that even these books can occasionally offer valuable insight into trading.

In The Perfect Swarm, Fisher shares the results of an interesting experiment which involved 2 groups of students, one from Germany and the other from America, to answer a simple question: Which city has a larger population, San Antonio or San Diego.

Seeing as how both cities are in the United States, one would expect that the American students would better be able to answer this question, as they knew more information about both cities than the German students.   Surprisingly, though, 100% of the German students guessed the correct answer - San Diego - but only about two-thirds of the American students knew the answer.

How did the German students do so much better?   The reason is that they simply had never heard of San Antonio, but they had heard of San Diego, so they naturally assumed that San Diego must be the larger city.   Clearly, in this case, having less information resulted in a better outcome.

Another book that touches on this notion that less information is better is Blink, by Malcolm Gladwell, who, incidentally, graduated from the same high school as I did in the small mennonite town of Elmira, Ontario.   Below is an excerpt from Gladwell's website:

One of the stories I tell in "Blink" is about the Emergency Room doctors at Cook County Hospital in Chicago. That's the big public hospital in Chicago, and a few years ago they changed the way they diagnosed heart attacks. They instructed their doctors to gather less information on their patients: they encouraged them to zero in on just a few critical pieces of information about patients suffering from chest pain--like blood pressure and the ECG--while ignoring everything else, like the patient's age and weight and medical history. And what happened? Cook County is now one of the best places in the United States at diagnosing chest pain.

The above example shows that looking at fewer variables has helped doctors save lives, but can the same concept help you become a better trader?   Think for a moment at how many variables you could look at when deciding whether or not to buy a stock:

  • Earnings, balance sheets, income statements, dividend yield, P/E ratios...
  • Analyst opinions, expert forecasts, news announcements, sales, new products...
  • FOMC meetings, ECB meetings, employment reports, GDP numbers, the election, inflation numbers...
  • Elliott Wave counts, fibonacci numbers, stochastics, RSI,  intermarket analysis, seasonality...

Just as doctors who looked at too many variables made poorer diagnoses, traders who look at all or most of these variables will likely make poor trading decisions.  What has really helped me in my trading is to, like the doctors in Chicago, reduce the number of variables to four:

  • What is the trend of the general market:  Up or Down
  • What is the trend of the stock in question: Up or Down
  • Is the stock in question making a new high:  Yes or No
  • Is the stock showing positive relative strength: Yes or No

I would say, therefore, that I am (unashamedly) an uninformed trader.   I'll end this post with a zinger from Nassim Taleb's book, The Bed of Procrustes:

To bankrupt a fool, give him information.

Added February 16, 2013: