How to tell when “sticking to your guns” is stupid

Hedgehogs, who look at everything in terms of “one big thing”, tend to make poorer decisions than foxes.

Yet markets are full of hedgehogs with big opinions, because big opinions help you raise money or get notice for research, or get invited on CNBC.

The trouble is hedgehogs tend to be closely related to lemmings when there is risk of danger involved. They often don’t last long. They get too attached to positions and too rigid in their views. They don’t see anomalies or contrary evidence. They resolutely go over the cliff together.

Nate Silver (continuing on from the last post) has a beautifully written way of putting it.

Every hedgehog fantasizes that they will make a daring, audacious, outside-the-box prediction—one that differs radically from the consensus view on a subject. Their colleagues ostracize them; even their golden retrievers start to look at them a bit funny. But then the prediction turns out to be exactly, profoundly, indubitably right. Two days later, they are on the front page of the Wall Street Journal and sitting on Jay Leno’s couch, singled out as a bold and brave pioneer.

Of course, sometimes being right means you have to be lonely for a while, and take a contrary view even when it’s unpopular. But it can also be a sign of being out of touch, or prejudiced, or unable to read the evidence objectively, or overconfident, or a crank, or naive about the limits of your domain knowledge. It can mean you’ve fallen for the dream of sitting on Jay Leno’s couch to the exclusion of reality.

Sometimes when your golden retriever looks at you a bit funny, even your dog realizes you’re wrong.

So it is essential to tell the difference between brave contrarianism and rigid imperviousness to contrary evidence, because the latter will kill you.

Once more, the key to success is a matter of the right degree of adaptiveness, which is usually a matter of maintaining a sense of balance. You adjust your view the right amount, at the right time. You need to be open, even eager, for things which might disconfirm your point of view, because you will always automatically seize on things that demonstrate your current view is correct.

Good traders set a stop-loss where they get out of a trade, and live to fight another day. Bad investors and amateurs ride losses all the way down, often becoming even more entrenched in the process. Even if the markets ultimate turn their way for a while, they’re already bankrupt.

Sticking to your guns.. till shot dead

I’ve found in practice one prime danger sign is when people start talking about “sticking to their guns,” especially when they disdain or even refuse to consider contrary evidence. It is the prime hedgehog virtue, or even fetish of rigidity for its own sake. The key distinguishing feature is their view is no longer falsifiable. It becomes a matter of ideology. In the worst cases, people will even try banning mentioning or thinking about any contrary evidence.

There are some terrible examples of this over the years, especially over Europe. It tends to bring out the true believers of one sort or another.

Let me give an example. The right wary to play Europe (and many other issues) is to recognize there is a cycle of overoptimism and pessimism, and lean against it – not go to one fixed rigid extreme or another. For example, in early 2012, the right way to trade was to think the prevalent “Europe has solved its problems” market view was going too far one direction, and prepare for bad news instead. When that indeed came, as Europe went to the brink of meltdown that summer, the right way was to recognize that is often the only thing that motivates action in the EU is the threat of disaster. So sentiment had become too pessimistic about the potential for policy shifts like Trichet’s “whatever it takes.”

The situation was still dangerous – as with the US government shutdown, there was still a small risk of catastrophe through accident or miscalculation. But chances were the danger would motivate an agreement. So the “risk-reward” calculation was to lean against pessimism, the other way.

In other words, to be contrarian at the right times you have to be agile and flexible, not fixed and rigid and devoted to one position.

Culture and foxes

Importantly, the right level of adaptability or flexibility is often embedded in a particular company culture. I worked at one market advisory firm when it was at a spectacular peak of success. In retrospect our “special sauce” was to get the right amount of flexibility and “foxiness” in the culture, which then reinforced itself as it produced strings of accurate calls. Remember, research shows that foxiness is the only thing that reliably separates out better performance at predictions.

We were multidisciplinary, with people from many different backgrounds. We went out of our way to find and understand different perspectives on events and people in their own terms, and then pinpoint the differences with conventional wisdom. We would talk and argue and debate for hours what events meant, what might happen, what people’s motives were, and what the right risk-reward ratio was on different angles of view. We agonized over balancing different points of view and “what-ifs.” It added up, organically, to the right level of adaptation.

One of the keys to our success at reading the Fed was a similar flexibility and ability to recognize cycles. The market tends to swing between “Fed not doing enough” and “Fed is behind the curve” like a sine wave. You just have to lean against extremes.

The right level of adaptiveness and flexibility and detachment usually beats deep domain knowledge (from hedgehogs) or raw information almost every time.