Apophenia is defined as, the “unmotivated seeing of connections” accompanied by a “specific experience of an abnormal meaningfulness”. For the full definition visit the wiki entry: –

http://en.wikipedia.org/wiki/Apophenia

Apophenia has come to imply a universal human tendency to seek patterns in random information, such as gambling, charts or data. It’s a flaw that afflicts many!

One of my favourite websites in recent years is Spurious Correlations. It details correlations that don’t make any sense. Definitive proof that correlation isn’t causation and that’s the key to accurate pattern recognition.

Apophenia and Gambling

Probably the best-known appearance of this in gambling markets is the gambler’s fallacy. This is when a long run of results lead gamblers to believe that ‘their luck must turn’. The fact is, good and bad runs are normal and there is unlikely to be a bias in the market unless you can describe why.

People are notoriously bad at assessing risk and some of this has to do with the fact that they can’t see what is random or not. Ask a computer to generate truly random numbers and you often get ‘unlikely’ runs occurring in the data. Ask humans to generate a random sequence and they don’t tend to put a truly random sequence down. Fraud management systems exploit this bias to spot potential issues.

Apophenia and Trading

When trading people often look at charts and ‘feel’ that the chart is telling them something. Using ‘feel’ is the most common fault behind Apophenia as that relies on human ‘insight’ and that’s the flaw.

Many moons ago, Humans had to use instinct to avoid being eaten by something or seriously injuring themselves in the quest for food. That’s not really a risk now, but that instinct still exists and it infects the way a lot of people approach making risky decisions.

Instinct still has a role to play though. as it can improve reaction time; but instinct on its own generally cannot be relied upon to make a fair judgement in a game of chance. After all, your money is at risk of being eaten when trading rather than you. But that still hurts.

Avoiding Apophenia

The only true way to avoid this inbuilt bias is to come up with an explanation of why what you are seeing occurs. If you can logically explain what you are seeing and put that to use, then you have no reason to resort to instinct. “This happened, then that happened and therefore this will happen”, Is the thought that goes through my mind when assessing risk. Yes, you still need to act on it, but knowing that you are using some logic will help you overrule doing something daft.

It’s a battle between logic and emotion. But the good thing is that it is possible to rebalance. How do I know? I had to go through it!

Taking risk – Finding the perfect trade

When you look at things academically, it often only explains in hindsight why something happens. It generally doesn’t always help you predict what is about to happen. Therefore pattern recognition can lead you don’t the wrong path when using historical data. You can make it fit whatever you wish!

In life, only two things are certain, death and taxes. The rest is a blend of possibles and maybes. Sometimes the possibles are very strong, other times it’s shrouded in a fog. So when trading you are trying to take all available information to conjure up a picture of what is happening now, but also how that information will influence exactly what is about to happen.

The trouble with the future is that it hasn’t happened yet. So that element of what you are doing doesn’t come shrink wrapped in a handy bag to take away. Whatever decision you make, there will always be an element of doubt in it.

This is where academics often stumble. If you analyse too much you find everything looks neat and there is no edge, so you don’t try. You don’t see the point, that’s understandable.

The fact is, you can’t eliminate all risk from something whatever you are doing, even if you are crossing the road. There is a demonstrable risk that something could go wrong. Even if you lie in bed all day to avoid risk, that brings an alternative type of risk. So you have to take a risk, somewhen, somehow. If you find yourself constantly asking ‘what if?’ then you are definitely a conservative risk-taker. If you say ‘what the hell’ then you are probably at the other end of the scale.

How to take risk

Natural risk-takers have a nice balance of understanding what they are doing, understanding the impact of their actions, but ultimately being able to press that button without fear. Of course, things could go wrong; but they could go very right as well! You are merely looking for a decent opportunity, it may not work, but that will all average out in the long term anyhow.

Ultimately, you are looking slightly ahead of where you are and trying to work out if the risk you are taking is fair, then waiting for it to happen. You could ask ‘what if’ a billion times, but it does NOTHING to mitigate any risk factors. All you can do is make a sensible judgement. Once that judgement is made you have to reassess and move forward.

If you mess up, you accept that and move on. If you got it right, you are not a god, you just took a good risk. Once in a position, you have to cope with another frailty, loss aversion. But that’s another blog post altogether!

How to spot a good risk-taker

A good proxy for the skill of a risk-taker is how long they have been doing it. Poor decision-makers, especially in sports or financial markets, pay the ultimate price. Loss of capital and a job! So longevity is a great proxy for spotting somebody that is good at taking a risk.

Embrace random

Generally in life and in the markets, if you do something at random you get random results. But, random results occur in a positive and a negative manner. Generally in equal proportion, especially in sports markets. So even if you were random, it would often balance out and may produce some surprise results.

Negative people are often so focused on negative situations, they turn out to be brilliant at finding them. So you don’t want to do that! But you also don’t want to be blind to risk.

Ultimately it’s a balance. But look for opportunities is my advice. They are everywhere and that’s the correct frame of mind. Don’t look for problems, or you will most likely find them!

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