Monday, October 27, 2008

Recency Effects and the Fallibility of Bloggers

Well, another painful truism from the excellent Despair site, which specializes in "demotivational" posters and products.

What occasioned this skeptical look at self and colleagues was a recent post from Trader's Narrative, which points to the questionable accuracy of blogger sentiment. A careful analysis of blogger sentiment from CXO Advisory found that the correlation between changes in blogger sentiment and changes in market direction was .33. This suggests that 11% of the change in blogger sentiment can be explained by how the market behaved during the prior week.

I once conducted an informal experiment in which I asked traders to predict market direction from a chart. All traders saw the same chart, but for half the group the last bar was rising; for the other half, the last bar was falling. Not surprisingly, the group that saw the chart with the most recent bar rising was significantly more likely to predict a bullish trend for the market than the group that saw the same chart with the most recent bar falling.

We are all victims of recency effects: the tendency to overweight events that are most recent, because those are freshest in our minds. Before I start trading for the day, I review news, economic reports, readings, and market indicators. I noticed a while back that my initial trades tended to reflect what I had most recently reviewed. Although I thought I was objectively weighing evidence, I was unconsciously overweighting what stuck in my head. Chastened by the uncomfortable realization, I added a final step to my preparation: a summary review of everything I had looked at, in hopes of weighing evidence more evenly.

There are many knowledgeable and talented bloggers out there. They, including myself, are not exempt from the behavioral finance biases that bedevil traders. In times of turmoil, people tend to look to perceived experts for advice. My inbox is bursting at the seams, with the number of emails from traders I receive up easily by 50% in the last two months. While I hope that this blog provides some inspiration and insight, I even more fervently hope that you read it with a critical mind. The lesson of the sentiment polls is that what you read might just be a reflection of what just happened in markets. You can seek information and perspective, but ultimately there is no substitute for being one's own guru.