On Being Wrong

. September 11, 2011
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Admitting we're wrong takes character. It means denying our own supposed omniscience and sovereignty. We live in a world which is uncertain and seems to make a habit of pointing out our mistakes.

Trading is one of those areas where our unwillingness to be wrong costs money. Do you remember when the S&P downgraded the U.S. credit rating in August? Nearly everyone I knew, including I, was saying that this downgrade would inevitably lead to higher long-term interest rates and that it was a great time to short bonds. As it turns out, the opposite happened. Long-term interest rates are lower today than they were in August.

We're Limited

Because we're human beings and not God, we have only a limited ability to take in and process information. As a result, we tend to think that whatever information we have is a comprehensive picture of the world, when in fact other things we haven't considered may be more important.

Why did interest rates go down in August? In retrospect, maybe the Euro zone crisis or the possibility of a recession in the emerging markets caused capital to flee to U.S. Treasuries, causing interest rates to fall despite the credit downgrade. It takes character to admit that we don't really know.

Follow Momentum

Using momentum as a market timing tool helps us admit when we're wrong. We buy in when upward momentum appears and sell when that momentum goes away. We admit that whatever our opinions about the world are, the potential cost of being wrong is far higher than the potential cost of selling too early. People who bought stocks in 2001 and early 2008 because the market was "cheap" and "couldn't go down any further" paid the price in a big way.

Because admitting that we're wrong requires humility, following a trading plan based on momentum takes character. We have to be willing to let mathematically calculated trading signals override our own opinions.

For more about momentum trading, start here.

Take a look at the TED talk below for more about the importance of understanding our fallibility.

Most of us will do anything to avoid being wrong. But what if we're wrong about that? "Wrongologist" Kathryn Schulz makes a compelling case for not just admitting but embracing our fallibility.