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A Thought Experiment to Help You Trade


Inductive versus deductive...

There are two types of reasoning, inductive and deductive. An example of inductive is we "observe" the sun rising in the East everyday therefore we conclude that the sun always rises in the east. An example of deductive is the earth rotates on its axis from what we call west to east therefore we deduce that the sun always will rise in the east.

Let's say you are put blindfolded on a train, the train is brought up to 70 miles an hour, and then you are told that the brakes on the train have been disconnected.

As you sit there you begin to think of what will happen. If you use inductive reasoning, the longer you sit there the more you become convinced that the train will not crash because it hasn't yet. You think the probabilities are decreasing that the train will crash.

Now let's use deductive reasoning. The train is moving fast. The track is not infinite. Since you know the only thing that will stop the train is a crash you therefore conclude that the probabilities of the train crashing soon are increasing.

The two methods reach the exact opposite conclusion.

It is my belief that too many traders/investors use inductive reasoning when approaching the markets. They are fooled into wrong conclusions because they are conditiioned to. Behavior is re-enforced even though that re-enforcement is actually changing the odds in exactly the opposite way.

I have heard this argument for example on the effect of growing debt on the economy and therefore its effect on asset prices. Total debt in the U.S. is now over three times GDP. Inductive reasoning tells many people that since nothing bad has happened to asset prices yet that the probabilities are decreasing that they ever will.

Deductive reasoning tells us that since, by definition, there has to be a level of debt that will eventually curtail consumption and that since debt is growing, we are getting closer to the point that high debt will curtail consumption.

Scientists have shown that the human race is more inductive than deductive. This is a root cause of what Scott calls the herd mentality.
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