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The Perils of Intuition

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Using intuition - induction - rather than deduction - is wholly irrational.

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John noted in his "Thought Experiment" article that "It is my belief that too many traders/investors use inductive reasoning when approaching the markets," and on this score, it is difficult to disagree with him: economic actors do use inductive rather than deductive - qualitative rather than quantitative - reasoning to assess risks and achieve their ends (those ends, we are told, are a maximization of utility).

Now, the question of which is optimal is of course also relevant. Last night on TV, John and Todd and I heard a comment from a professional blackjack player that was instructive in this regard. Asked what one of his best tips would be to novice card sharks, he said "people should use their intuition" when playing.

Simultaneously, John and I started laughing and simultaneously said out loud: "that's exactly the wrong thing people should be using!"

Why?

When you are playing blackjack, you are dealing with a set of discreet and static probabilities that are a function of the deck. The probability that a face card is going to come up is a function of how many face cards are in the deck at the start and how many have been drawn. What a player thinks or perceives about the probability of face cards is moot. Believing that there is a 7% chance to getting a face card on the next draw in no way increases or decreases the ACTUAL probabilities. Thus the probabilities are static. Using intuition - induction - rather than deduction (that is cold hard probabilities via card counting) - is wholly irrational. Not only won't it help, it could actually hurt quite a bit. That's why we laughed: he gave the one piece of advice that he SHOULDN'T have.

Stock markets, like blackjack games, are games of probability. But there is a critical difference. Negotiated markets involve dynamic (in a sense) rather than static probabilities. They are dynamic because what I think about the probabilities of a stock going up or down impacts the actual probability itself. If I think a stock has a high probability of going up, I buy it and, in a small way, cause it to do so. Thus my perception affects the probabilities, which is not at all the case with cards: you can count cards and gain an advantage. You can't count stocks and get the same. (Parenthetically, this is the 'reflexivity' that George Soros often writes about.)

This is not to say that intuition is not an evolutionary advantage; that it doesn't serve some purpose. Certainly using intuition in playing poker is a must: determining the likelihood of an opponent bluffing is critical to risk management and intuition - induction - could prove highly useful in that situation.

Brian Arthur, one of my favorite economists and Santa Fe Institute scholars, has written on this phenomenon extensively. A specific paper on the subject is entitled "Inductive Reasoning and Bounded Rationality" published in 1994 (Google it).

"How do humans reason in situations that are complicated or ill-defined? Modern psychology tells us that as humans we are only moderately good at deductive logic, and we make only moderate use of it. But we are superb at seeing or recognizing or matching patterns--behaviors that confer obvious evolutionary benefits. In problems of complication then, we look for patterns; and we simplify the problem by using these to construct temporary internal models or hypotheses or schemata to work with....This type of behavior may not be familiar in economics. But we can recognize its advantages. It enables us to deal with complication: we construct plausible, simpler models that we can cope with. It enables us to deal with ill-definedness: where we have insufficient definition, our working models fill the gap. It is not antithetical to "reason," or to science for that matter. In fact, it is the way science itself operates and progresses."

In stock markets too induction may play a beneficial role - but it can also be quite dangerous when used exclusively, without any deductive process. Just as there are times - regimes - where markets are efficient, there are times when markets are inefficient - and non-linear. A combination of induction and deduction is more powerful than simply herding - than simply induction - alone.

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