Saturday, October 28, 2006

Can There Be An Objective Basis For Subjective Knowledge?

In my recent post, I cited Ayn Rand's assertion that philosophy is the most practical of disciplines. This is particularly true with respect to epistemology, that branch of philosophy that deals with knowledge and its acquisition. What we count as truth ultimately determines how we pursue truth, whether in markets, science, or politics.

Ms. Rand also stressed that contradictions cannot exist in reality. Where we find a contradiction, she advised, check your premises. At least one of them will be incorrect.

The positivism expressed by David Aronson's fine book Evidence-Base Technical Analysis yields just such a contradiction. Before I launch into the contradiction and a possible resolution, allow me to mention (on an unsolicited basis!) that Aronson's book is a substantial contribution to the literature on technical analysis. One need not agree with his strident formulation that the discretionary application of technical analysis does not draw upon "a legitimate body of knowledge but a collection of folklore resting on a flimsy foundation of anecdote and intuition" (p. 261) to benefit from the reading of his work.

Specifically, Aronson has accomplished four worthy ends:

1) He clearly explains the importance of testing trading ideas and illustrates how that is done;
2) He describes both the strengths and potential weaknesses of data mining approaches;
3) He tests specific technical trading patterns and demonstrates how difficult it is to obtain statistically significant findings (and how easy it is to generate illusory ones);
4) He reviews major theories and research findings in behavioral finance to help traders begin the process of finding more promising patterns.

For a book that deals with technical themes of logic and mathematics, his work is eminently readable and understandable. I would rate it alongside Kenneth Grant's "Trading Risk" as a must read for developing traders.

That having been said, I believe Aronson's positivist roots--leading him to equate knowledge with declarative statements known to be true--create a Randian contradiction. If all knowledge consists of verifiable statements about observables, then Wittgenstein is correct in his formulation: Whereof we cannot speak, thereof we must be silent. Subjective knowledge must be an oxymoron.

But here is the contradiction: It is common--certainly in my visits to proprietary trading firms, hedge funds, and investment banks--to find discretionary traders who have achieved a high level of trading success year after year, trading actively. Indeed, I wrote about just such an individual in my new book on trader performance. These are not mere anonymous figures on bulletin boards puffing up their performance stats. These are traders who have account statements and risk managers able to verify their superior performance. And yet they cannot verbalize specific rules or systems for their trading.

In short, they have knowledge, but it is not of the verbal, declarative kind.

The existence of such implicit learning has been known in cognitive neuroscience circles for decades. Philosopher Michael Polanyi offered an influential treatise on tacit forms of knowledge, and Arthur Reber began his groundbreaking studies in the 1960s, culminating in his 1993 text "Implicit Learning and Tacit Knowledge". More recently, Timothy Curran, in the "Handbook of Implicit Learning" summarized research that found different brain mechanisms mediating implicit learning and explicit, verbal knowing.

How does implicit learning occur? Through intensive repetition, in which individuals become sensitive to complex and noisy patterns. This is how young children learn to speak grammatical English before they can verbalize the rules of English grammar. It's also how we can identify a face that we could never adequately describe in words, and it's how we know when such a face is starting to display anger or sadness. Serial reaction time experiments show that subjects can learn complex statistical probabilities in sequences of data with enough repetition and feedback. Interestingly, they can anticipate events in those sequences, but cannot verbalize the complex patterns that they have internalized. (The research of Axel Cleeremans is particularly eloquent on this point).

Such subjective knowledge is not "devoid of information" as positivist philosophy would have it. There are, of course, intutions that prove to be invalid, but reducing all knowledge to testable hypotheses would probably eliminate most of the knowledge and understanding that lies behind great art, as well as most performance fields such as athletics. The deep knowing of musicians, chess players, and fighter pilots can hardly be reduced to sets of explicit propositions.

If we admit the possibility of such subjective knowledge, then it follows that the development of algorithmic systems with fully backtested rules is not the only way to achieve trading success. It may be possible to generate success by accelerating processes of implicit learning through the use of simulation/replay and intensive feedback. Ironically, the weakness of much technical analysis is not that it is subjective, but that it pretends to an objectivity that it cannot support.

Can there ever be an objective basis for subjective knowledge? I believe so. A trader's track record of profit/loss can be compared to random entries/exits (as well as buy and hold) to objectively determine whether or not that trader--over time--exhibits significant skill. Imagine a Monte Carlo simulation in which we create random entries and exits each day that a trader trades, with identical trading frequency and holding times. Suppose that such a simulation is conducted 10,000 times by computer. The resulting distribution of P/L would display the likelihood of achieving a given level of profitability by chance alone. If a trader's subjective trading methods consistently produce results at the very upper tail of that distribution, we can objectively infer that the subjective trader is skilled.

In other words, by treating each trader as a trading system, we can evaluate that trader's level of knowledge, regardless of whether the knowledge is subjective or objective. In the absence of such score-keeping, discretionary traders have no basis for a belief that they possess a true edge in the marketplace. One need not resort to positivism--or system-based trading--to be rigorously scientific. It is precisely because intuitions are fallible and human senses are so easily deceived that we need to distinguish truly superior outcomes from merely random ones.

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