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Wednesday, August 10, 2011

How to lose money

The entire modern "Science" of investing is built around reversion-to-the mean models. This model claims that over time markets will trade in simple reliable channels that even idiots can understand and predict. Especially idiots with pipes, nice suits, and soothing voices who will assure you that Now is always the right time to invest - according to their models.

Unfortunately for you - if you listen to them - these idiots have never learned the difference between correlation and causality. And their models are all built on correlations.

Ancient Greeks understood this confusion between causality and correlation and built a syllabus of logic that they taught to school children. They called it "syllogism." The famous false syllogism purposely confuses the fact Plato drinks water, and horses drink water, so Plato must be a Horse. That's about as sensible as saying that markets always bottom, PE's have been around 12 when markets bottom, PE's are around 12, the market must have bottomed.

In both cases the best you can say is Maybe. But much more information is needed to conclude causality.

See if you can find the fallacies with these other false syllogisms in current favor:

1) Stocks have gone up when dividend yields are above the yield on the 10 year note. Dividend yields are above the ten year note. Stocks will go up.

2) Stocks have gone up when the yield curve is positively sloped. The yield curve is positively sloped. Stocks will go up.

3) Gold stocks have performed well during depressions. We're going into a depression. Gold stocks will do well.

4) Stocks are a good buy when corporations have a lot of cash on their balance sheets. Corporations are holding 3 trillion dollars in cash. Stocks should do well.

Hint for number 4: But what about if the same corporations are also holding 11 trillion dollars of debt?

Every correlation will have dozens of mitigating and contradicting factors. You should be able to find many for all of the false syllogisms above.

If, however, you can't find the fallacies, you shouldn't be in the markets. And if you can, right now, you wouldn't want to be.

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