Why Markets Trend

I really liked this way of thinking about trending markets courtesy of the Michael Platt chapter in Jack Schwager’s excellent Hedge Fund Market Wizards.  Platt founded the $25 billion hedge fund BlueCrest thirteen years ago. It is one of the ten largest hedge funds in the world and has become well known for its dedication to risk management.

Here’s Platt (emphasis mine):

One of the only things I could say with certainty was that markets trend because I can observe trends in any financial market, in any time era. You could go back 150 years in cotton futures, and there are trends everywhere. The same is true for equities, bonds, short-term rates, everything.

It seems illogical that markets trend. Markets should discount all information and then be static waiting for the next piece of information before changing price level. But that is not what they do. And the reason they trend is because our minds just don’t work properly. We make an estimation of the future based on all of the knowledge we have of the past at the current moment…

If the market is going up today, your forecast is going to be that it will continue going up because it is how you feel at the moment that is the most important thing. Today becomes how you felt in the past because you misremember, So everything is about today. If it is going up today, it will go up tomorrow. In this sense, financial markets become self-referential.

Michael nails it here. I see this kind of thing everyday, writ large, in real-life. People (including myself) think about the next day or week in terms of what is happening right now.

Watch an hour of financial television on a green day for the markets, you’ll hear confidence in the voices of almost all of the guests. Then watch for an hour on a day in which an economic report misses forecasts or the Fed says the wrong thing, you will pick up on the caution that has crept into everyone’s demeanor – even the names and themes of the segments are skewed negatively to “match” the prevailing feeling of the day.

You’re only human, you should not expect to be able to overcome this cognitive bias all the time. But I find that just being aware of it – within yourself and among the people around you – might be good enough.

Markets trend because we overemphasize the relevance of what’s happening today and act accordingly the next day by repeating the same actions – buying on the way up, selling on the way down. The “reasons” we assign to explain our actions and the embellished narratives we create around them are only there for decoration.