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Even the billionaires have this problem

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From Richard Smith, Founder, TradeStops:

Eric Arthur Blair — better known by his pen name, George Orwell — is the British author who wrote the timeless classics Animal Farm and 1984. Phrases still in use today — like Orwellian, Big Brother, and Thought Police — are a result of those novels.

Orwell was also known for his essays. In 1946, the year after World War II ended, he wrote the following in a piece titled “In Front of Your Nose:”

“We are all capable of believing things which we know to be untrue, and then, when we are finally proved wrong, impudently twisting the facts so as to show that we were right. Intellectually, it is possible to carry on this process for an indefinite time: the only check on it is that sooner or later a false belief bumps up against solid reality, usually on a battlefield.”

Orwell also has a famous quote: “To see what is in front of one’s nose needs a constant struggle.”

Long before the phrase “cognitive bias” gained attention in the 1970s, Orwell and many others (all the way back to the ancient Greeks) knew something basic about human nature.

It can be very hard to see what is “in front of your nose” — in other words, the glaring evidence right in front of you. There are countless ways to be distracted or misled … or focused on the wrong thing … or thrown off balance by emotion … or a dozen other things.

At the same time, every so often and seemingly like clockwork, there’s an example in the news where human judgment fails spectacularly.

Such-and-such person makes a decision (or a string of decisions) so terrible that the age-old question arises: “How could anyone make such an obvious mistake? How in the world did that happen?”

They probably failed to see “in front of their nose.” And it was probably due to cognitive bias.

Cognitive biases help explain the “why” behind certain bizarre quirks of human nature

They can be described as “systemic patterns of deviation” from rational thought.

These biases are “systemic” in the sense they are built into the brain, which means everyone has them as part of the brain’s default setting. They are not glitches or flaws in day-to-day functioning, but a result of the brain’s architecture.

Cognitive biases are literally everywhere. Anyone with a brain is susceptible to them.

But how do cognitive biases make it hard to see something obvious?

Take confirmation bias — one of the better-known biases (there are hundreds of them) — as an example. Confirmation bias is the tendency to filter information in a way that supports a desired belief.

If you deeply want to believe “X,” for example, your brain will seek out and register information that confirms the validity of X. At the same time, your brain downplays or ignores inputs that go against X.

The stronger your desire to believe something, the more powerful this effect becomes.

Confirmation bias can sometimes be so strong that it creates a reality distortion field — where the person in the grip of the bias is no longer able to process reality accurately.

In markets, this can get expensive. The problem is that different cognitive biases can combine and reinforce each other, leading to irrational behaviors that cost a lot of money.

You may have heard a version of this joke:

Q: What do you call a short-term trade that doesn’t work out?

A: long-term investment.

Here’s how that works:

Bob believes a certain stock will have strong earnings and a string of profitable quarters ahead. He buys the stock, assuming the earnings report will be a catalyst for a nice move higher.

Alas — the earnings report is bad. The company failed to meet expectations. The outlook is “meh” and was supposed to be great. The stock goes in the wrong direction. It gaps down and starts drifting lower.

At this point, Bob experiences the cognitive bias known as “loss aversion.” His desire to avoid a loss is stronger than his desire to seek gains. So, he holds onto the losing position.

If he waits a little while, Bob reasons, then maybe the stock will come back. Never mind that his whole thesis for buying the stock in the first place (strong earnings and rising profits) has been trashed.

Now that Bob’s short-term trade is a “long-term investment,” he has a vested interest in seeing the stock go up. This translates to an emotional desire — Bob deeply wants the stock to make a comeback.

Confirmation bias then takes hold: Bob’s brain starts paying attention to articles that are friendly to the idea the stock might come back … while discounting or ignoring evidence that the stock could go lower.

There is so much written about publicly traded stocks, it’s almost always possible to find a bullish article or someone making a weak bullish case somewhere — even if the stock is a total dog. Caught in the grip of confirmation bias, Bob seeks out these bullish articles. The stock keeps falling.

Bob ignores the strongly negative evidence — the warning signs in front of his nose — and stays with the position. A year later, the stock has fallen dramatically … and badly damaged Bob’s portfolio.

This can happen to anyone. It even happens to hedge-fund billionaires.

The tricky thing about cognitive bias is that, much of the time, you don’t even know it’s there. The bias factors play out in the realm of the subconscious.

At no point did Bob (our hypothetical investor) realize that he was acting irrationally as the stock kept going down. In the real world, Bill Ackman (a billionaire) did the same with Valeant Pharmaceuticals.

But cognitive biases can be trickier still — because they still distort things even when you spot them.

When a bias is strong enough, it creates a form of “cognitive illusion.” This causes you to see something that isn’t there, or to wrongly perceive an irrational course of action as rational. And even if you recognize what’s happening, the illusion persists.

We can use a visual cognitive illusion to demonstrate the point.

The “Müller-Lyer Illusion” was developed in 1889 by Franz Carl Müller-Lyer, a German sociologist. A version of it from Daniel Kahneman’s book, Thinking Fast and Slow, appears below.

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As you look at the illusion, ask yourself: Which of the two horizontal lines is longer?

The correct answer is: It’s a trick question. Both of the horizontal lines are exactly the same length. (You could prove this by taking a measurement.)

The illusion persists even after you know the correct answer. The bottom line still looks longer, even when you know the truth. This is due to a quirk of how the brain works and how certain shapes are interpreted relative to depth perception.

Certain types of cognitive bias can create a similar type of illusion. But these illusions are patterns of thought or beliefs rather than visual brain teasers. That makes them far more dangerous.

In the world of investing, persistent cognitive illusions (created by built-in cognitive biases) can lead to irrational decision making, which winds up costing investors money. Sometimes a LOT of money.

And the real challenge is, you can study up on the various biases … and be fully aware that you have them (just like everyone else) … and still fall victim to them anyway.

This is another benefit of using a set of rules that exists outside your brain … while interpreting market data with the help of software that informs and guides decision making.

A well-designed software algorithm doesn’t see with human eyes. Technically speaking, it doesn’t “see” at all. It just crunches a vast stream of ones and zeroes. That helps make the algorithm a reliable interpreter — an impartial judge, if you will — when programmed correctly.

And this, again, is why software can be such a help to investors.

You won’t always know when your cognitive biases (which all investors share) are negatively impacting your investing decisions. And sometimes those biases will distort your perception … even if you are well aware of them and know they exist.

But well-designed investment software can help you see “in front of your nose” in terms of making rational decisions with the help of data — thus increasing the likelihood of investment success.

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Richard

Crux note: As if the the challenge of savvy investing wasn’t hard enough, you have to fight against your own subconscious… But that’s why Richard created TradeStops.

His philosophy is to cut your losses and let your winners ride… And the results speak for themselves.

You can discover why one satisfied investor called TradeStops his “safety net” right here.


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Charts show steady investor optimism, more upside for stocks

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The stock market rally that began 2019 has not yet run its course, even with Tuesday’s Washington-induced surge, CNBC’s Jim Cramer said after consulting with technician Carley Garner.

“The signs suggest that this market can have more upside before the rally exhausts itself,” Cramer recapped on “Mad Money.” “Eventually the market will become too optimistic and stocks will peak, but we’re not there yet.”

Garner, the co-founder of DeCarley Trading and author of Higher Probability Commodity Trading, has an impressive track record. In mid-December, one week before the Christmas Eve collapse and subsequent rebound, she told Cramer that pessimism was peaking and stocks were due for a bounce.

But now that the S&P 500 has gained over 15 percent since those midwinter lows, it’s worth wondering the reverse: what if optimism is approaching its peak?

Lucky for Wall Street, Garner says it’s not. She called attention to CNN’s Fear and Greed index, which uses a variety of inputs to measure what CNN sees as investors’ chief emotional drivers.

Right now, the index sits at 67 out of 100, signaling more greed than fear, but still “a far cry from the extreme levels where you need to start worrying,” Cramer explained. When the major averages peaked going into the fourth quarter of 2018, the index hit 90, and according to Garner, “we usually don’t peak until we hit 90 or above,” he said.

Add to that the fact that only half of professional traders and investors polled for the most recent Consensus Bullish index said they felt bullish; the recent downtrend in the Cboe Volatility Index, which tracks how much investors think stocks will swing in the near future; and that, historically, this is a good time of year for stocks; and Garner sees more momentum ahead.

The S&P 500’s technical charts seem to uphold Garner’s theory. Its weekly chart shows fairly neutral readings for two key indicators: a momentum tracker called the Relative Strength Index and the slow stochastic oscillator, which measures buying and selling pressure.

“Even if the S&P 500 keeps climbing to, say, … 2,800 — up 2 percent from here — Garner doesn’t anticipate either the RSI or the slow stochastic [to] hit extreme overbought levels,” Cramer said, adding that the technician could even see the S&P climbing to 3,000 if it breaks above the 2,800 level.

If Garner is wrong and the S&P heads lower, she said it could trade down to its floor of support at 2,600, and if it breaks below that, fall to 2,400. But that scenario is highly unlikely and, if it happens, would be a buying opportunity, she noted.

The S&P’s monthly chart told a similar story, Cramer said. The index is currently trading at 2,746, between its “hard ceiling” at 3,000 and its “hard floor” of 2,428, he said, which means it’s “basically in equilibrium.”

“To Garner, that means going higher is the path of least resistance for the S&P,” the “Mad Money” host said. “Once the S&P climbs to 2,800, or perhaps … to the mid-2,900s, that’s where Garner expects things will turn south and the pendulum will start swinging in the opposite direction.”

“Remember, … Carley Garner has been dead-right, and the charts, as interpreted by Carley, suggest that this market still has some more upside here,” Cramer continued. “But if we get a few more days like this wild one, she thinks we’ll need to start worrying about irrational exuberance. For now, though, she thinks we are headed higher, and I agree.”



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What Jeff Bezos’ private life means for investors

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Daniel Ek, chief executive officer and co-founder of Spotify AB.

Akio Kon | Bloomberg | Getty Images

Daniel Ek, chief executive officer and co-founder of Spotify AB.

Cramer said Wall Street has misread Spotify‘s latest earnings report and guidance, and that misunderstood stocks like these give investors an opportunity to make some money.

he called out stock analysts like Everscore ISI’s Anthony DiClemente who have downgraded the equity over concerns about subscriber growth.

“I think this is lunacy,” said Cramer, who has been bullish on the music streaming platform since it went public last April. “It’s like the market just doesn’t know how to read this company or its quarterly guidance. In my view, Spotify is very much on the right track.”

The stock was rocked after a seemingly mixed quarterly earnings released Wednesday, Cramer said. After Spotify reported lower-than-expected sales, tight cash flow and conservative guidance across the board including subscriber growth, shares sold below $129 at one point in Thursday’s session.

But Cramer noted that the company beat expectations on operating profit and gross margin, which was 120 basis points higher than was asked for.

“I think the sellers were missing a lot of context here and the context is something I like to talk about a lot and it’s called UPOD. They under promise … and then they over deliver,” he argued. “At this point, CEO Daniel Ek and his team have established a track record of giving cautious guidance—under promise—and then beating it—over delivering.”

Spotify’s guidance includes planned investment costs and the company could “become the premier platform for podcasts,” a hot market for hard-to-reach millennials, Cramer said.

Click here to read Cramer’s full take.



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Charts show investors ‘can afford to be cautiously optimistic’

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Investors can afford to be “cautiously optimistic” at this point in the stock market’s cycle, CNBC’s Jim Cramer said Tuesday after consulting with chartist Rob Moreno.

Moreno, the technician behind RightViewTrading.com and Cramer’s colleague at RealMoney.com, sees a convoluted path ahead for stocks. After calling the December bottom, Moreno noticed that the Nasdaq Composite’s late-2018 decline was about a 24 percent drop from peak to trough.

That’s important because, in a bull market, stocks tend to see “periods of consolidation — pauses in a long-term bull run,” Cramer explained. “To [Moreno], the decline here looks very similar to what we saw from the Nasdaq in 2011, 2015 [and] 2016,” three consolidation periods of recent past.

If he’s right, that could be bad news for the bulls, who may have to wait at least seven months for stocks to break out of their consolidation pattern, during which they tend to trade in a tight range, Cramer warned. But Moreno still sees some opportunity for investors.

“If you believe his thesis about the market — that we’re in a consolidation period, one that will last until September — then you can afford to be … cautiously optimistic right now,” Cramer said on “Mad Money.”

Part of Moreno’s confidence came from his analysis of the S&P 500’s daily chart, which also included the support and resistance levels from its weekly and monthly charts.

Even after a 16 percent rally from its December lows, Moreno saw more room to run for the S&P based on its Relative Strength Index, or RSI, a technical tool that measures price momentum. The RSI, he explained, hasn’t yet signaled that the S&P is overbought, and the Chaikin Money Flow, which tracks buying and selling pressure, shows big money pouring in.

“Moreno thinks that these new buyers are the kind of investors who won’t be panicked out of their positions by short-term volatility,” Cramer said, adding that the technician sees about 3.5 percent more upside for the S&P before it hits its ceiling of resistance at 2,818.

But if the S&P manages to trade above its ceiling of resistance and return to its October highs, Moreno expects a “synchronized reversal” in the stock market that could crush the major averages, the “Mad Money” host warned.

“At least until September, Moreno says you should be a seller if the averages approach their October highs — that’s around 2,930 for the S&P 500,” Cramer said. “Eventually he expects a breakout from these levels, but it won’t happen any time soon.”

So, what’s the right move for investors? According to Moreno, not all is lost. He still expects to see strong gains — a roughly 7.5 percent move — before the current rally peters out. But he doesn’t want buyers to get too trigger-happy, especially considering the months of sideways trading he’s predicting for 2019.

“Until [September], he expects the market to trade in a fairly wide range, with the S&P bouncing between 2,350 and 2,930. For now, we’re headed higher, but he says you should use these key levels as entry and exit points until the consolidation pattern finally comes to an end later this year and the averages resume their long march higher,” Cramer said. “Even if he’s right and this rally will lose its steam after another 7.5 percent gain, that’s still pretty good, but I am very wary and it makes me want to do some selling after this run.”



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