Best of TTU – Market Psychology & Universal Truths

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A while back, I had a very enjoyable time speaking to Scott Foster from Dominion Capital Management, who is not your typical Trader. He draws from a wide range of influences such as Aristotle, Magic, and Austrian Economics. I am delighted to share some of these deep insights with you in this short blog post, and I hope you enjoy these unique views and observations from Scott. If you would like to listen to the full conversation just go to Top Traders Unplugged Episode 27 and Episode 28.

A Blend of Philosophy & Psychology in the Markets

Scott: I approach the whole trading situation from a real blend of philosophy and psychology. We’ve talked a little bit about the psychology stuff, not a lot, but the philosophy really to me was a bigger element, a bigger issue in terms of pushing me in a certain direction in how my trading is going to look and what I needed to do to support a particular style of trading. That goes back to it’s a gradual process that’s happening in those earlier years that I was talking about trading for myself and trading for this small trading group that I put together and then my experiences – my three years as a Senior Trader at A.L. Management. You go through this whole process and as the whole time I’m looking at what is my strategy? How do I want to approach the markets? What is my strength? What do I want to do? I kept having a problem reconciling all the different strategies that I was reading about.

Scott-Foster-2

There was a certain philosophical hiccup in my brain that I could not get my arms around. What it was, was the fact that my background in philosophy is more geared toward ancient philosophy. My father got me turned on the Aristotle and Plato and the Socratics at an early age and he was my professor for a lot of my classes in college. I was either well educated or brainwashed; I’m not sure which perspective I want to take, but I had a real passion for the classics and Aristotelian logic in particular. So the markets that I’m looking at I’m thinking OK, how do I want to trade? I’m thinking do I want to be…it seemed to me it didn’t matter what I picked.

If I was going to trade the markets on a fundamental basis, I am basically saying that I am looking back in the past and I’m looking at certain fundamentals that would make something cheap or expensive or that’s what everybody says, that this stocks to use ratio the price ought to be X, or when this happens, or whatever, if you are in the stock market, the PE ratio.

“For my field of study, which is Epistemology – the theory of knowledge – how do you know you know? How can you validate or verify anything that you know, and what gives you any confidence in what you believe is true?”

You are looking at all these different events in the past and you are saying this will tell me in the future what value is and what it ought to be. If I am a technical trader I am going to look at the past and say here’s a head and shoulders pattern and most of the time if that happens in the past… I’ve counted 75 times that it’s happened out of X it seems to point in the future that this is going to happen. Pick a strategy, any strategy, at the end of the day I ran into a real difficulty with trying to understand just because it’s happened in the past why does that mean it’s going to happen in the future? For my field of study, which is epistemology, which is the theory of knowledge – how do you know you know? How can you validate or verify anything that you know and what give you any confidence in what you believe is true?

Niels: So universal truth I guess.

Scott: Exactly and that’s what Aristotle basically said. He basically invented logic as what everybody accepted for 2,000 years. Everybody has been debating over the last 100 years or so whether it was right or not. He said in classical logic and syllogistic logic that when we put these propositions together: all men are mortal, Socrates is a man therefore Socrates is mortal, we can evaluate their truth by looking at what he called the square of opposition, which is if you drew a square on a piece of paper in the upper left hand corner, that stood for the universal affirmative.

toll bridge

For example, I could say all toll bridges are expensive, so in the upper right-hand corner is the universal negative: all toll bridges are not expensive. Down in your lower left hand corner is the particular affirmative at least one toll bridge is expensive and in the lower right-hand corner is the particular negative: at least one toll bridge is not expensive. Aristotle went on to try and argue we have inferences that are true always by looking at the relationships between these four propositions. For example, the top two the universal affirmative and the universal negative, they’re called contraries. They both can be false, but the both can’t be true.

The relationship between the particular affirmative and the particular negative is sub contrary, and it’s the exact opposite, both can be true, but both cannot be false. The relationship between the universal affirmative and the particular negative is called a contradictory, and they both cannot be true and they both cannot be false – one has to be one, one has to be the other.

The relationship that had the most important bearing on my understanding of trading was the sub alternative relationship, which is the relationship between the universal affirmative and the universal negative. If all toll bridges are expensive, then the particular affirmative, at least one toll bridge is expensive has to be true, but the reverse is not true. If you say, at least one toll bridge is expensive there’s no way that implies that all toll bridges are expensive. However, the opposite is true – the reversal of that. If you say at least one toll bridge is not true, you have proven false the universal affirmative that all toll bridges are true which falls into a different line of thinking called falsification, and Popper gets into that. I was more intrigued by the universal because Aristotle was very consumed by universals. The things that were always true. Getting into natural law and so forth.

socrates

“I thought to myself, I’m looking at particulars when I should be looking at universals, so what are the universals that I can trade from?”

The relationship that had the most important bearing on my understanding of trading was the sub alternative relationship, which is the relationship between the universal affirmative and the universal negative. If all toll bridges are expensive, then the particular affirmative, at least one toll bridge is expensive has to be true, but the reverse is not true. If you say, at least one toll bridge is expensive there’s no way that implies that all toll bridges are expensive. However, the opposite is true – the reversal of that. If you say at least one toll bridge is not true, you have proven false the universal affirmative that all toll bridges are true which falls into a different line of thinking called falsification, and Popper gets into that. I was more intrigued by the universal because Aristotle was very consumed by universals. The things that were always true. Getting into natural law and so forth.

So I thought to myself, if I’m looking at a toll bridge, toll bridge, toll bridge, toll bridge, therefore, all toll bridges. How is that any different than looking at head and shoulders, head and shoulders, head and shoulders and drawing some conclusion that really didn’t seem to logically come about. It’s like saying white swan, white swan, white swan, therefore, all swans are white. Logically and basically the subaltern arrangement here, this understanding of Aristotelian logic is really at the basis of so many financial implosions that conclusions and ideas that are treated as universals because of witnessing the particulars whether than the other way around. I thought to myself, I’m looking at particulars when I should be looking at universals, so what are the universals that I can trade from?

What is something that will be true tomorrow, true the next day, true the next day, true until forever and if it’s true forever than it can’t be empirically validated. So it has to be accepted as true and so like a natural law, it’s understood. It’s like 1 + 1 = 2. Well, I can do 1 + 1 a million times and get 2 but the only way I can say that it’s universal is to say that I accept it that it will always be that way because it is. It can never be empirically validated. I find myself as an Aristotelian approaching the markets from what I would call a deductive point of view rather than inductive. We start with universals, and we reason everything that we do we basically believe you could do it if you were locked in a closet most of your life because it’s necessarily true. It is not something based upon data.

This is, not to get off topic, but we talk about Dominion being a firm that looks at the world through Austrian economic eyes not because we make economic pronouncements, but the methodology of Austrian economists, the process is, that’s their epistemology, it’s very deductive, it’s not empirical, it’s not because we found 47 people that have benefited from minimum wage therefore it must work. It’s not about working it’s the principle, or the universal is true and must be true even if you don’t see it to be true. I kept thinking to myself what can I focus on here that will help me. There are a couple of things that I discovered, but as it pertains to what we do in Dominion from day 1 to now is the psychology. The psychology of the markets is my universal affirmative. In other words, how people make decisions isn’t going to change tomorrow, the next day, the next day, and it’s not because of the studies that Tversky and Kahneman did and how they basically created portfolio theory as a science. This existed well before. it was something that was discovered, not something that anybody created.

This is the way people process information and they will always process it that way, and if that is true, which I believe it very much to be true, and we could get a lot deeper into philosophy and religion and all that to debate that issue, but if you’ll grant me that, that’s our starting point. So when we build a trading model, we build everything from that top down. We don’t look at data a say what works and what can we do and how do we create a short term trading system? We look at it and say how do people make decisions? How are they trapped in these bad decisions? How can we capture that? It’s very, very specifically in the market place.

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