Reasonability and Sensibility

December 20, 2018. Following the Fed rate hike, stock indices dropped to new lows to confirm the entry of a bear market. This should not be a surprise to a significant portion of stock traders. Back to October this year, many people already had a pretty firm belief (still not 100% sure, as there is never ever a 100% certainty in this world) that the Bear was approaching to kill. And for some of them, the whipsaw patterns within last two months have been nothing but a further confirmation that the market was on its way to fall, and to fall heavily. However, not many of these believers took home a good profit even though their prediction turned out to be correct. Why? This question got me to examine two concepts: reasonability and sensibility.

In this article, “reasonability” means decision-making based on pre-defined strategy which is derived from tremendous collection of relevant data and analysis, while “sensibility” involves spontaneous judgment, emotionality, or power of feeling.

Reasonability

A quant trader may embrace reasonability if he is sufficiently self-disciplined. However, a human being tends to experience colour-tinted reality (as Immanuel Kant believed and pointed out), and therefore might make bad decisions depending on the colour filters he uses. Furthermore, at hindsight a person might consider that all of what is happening now is completely predictable, but in fact this very person either did not have a clear prediction of the market direction in the uncertain time or could not assign a rough probability to his predicted scenarios. So it is better to turn to machines for help.

Nowadays many institutions have in place algorithm-based trading programs, which take into consideration elaborately wrought models and arguments. Other than key variables such as time, price, volume and historical behaviour patterns, some algorithm also includes changing factors such as press headlines to address the limitation of being static. It can be said that these algorithms have a great deal of reasonability and therefore have a huge advantage to a human trader whose mind could be easily clouded by emotions or misconceptions. Nevertheless, such programs created for embedding reasonability do not guarantee profit, because they do not incorporate sensibility sufficiently.

Sensibility

It is obvious that there is in the stock market a force called “sensibility”, which was defined above. Very often we hear assessment of it when someone says “a fear rises from the market that the worst is yet to come”, or “a rebound seems likely because I feel this stock was over sold”, or “I can’t risk taking more exposure no matter how the market change as I have lost 30% of my portfolio”, and etc. Surprisingly, this concept has not been extensively examined and explored in the academic literature.

If we say reasonability has more to do with history repeating itself to some extent, then sensibility is somewhat independent from the data and arguments accounted in the logics and algorithms of reasonability, i.e., it refers more to the belief that history may not repeat itself given the new circumstances.

Take the Fed rate hike as an example, which is simplified and isolated solely for the purpose of illustration. When the Fed said there would be rate hikes, the stock market slipped due to both reasonability (assuming this is represented by the factor of “headline” in the trading model) and sensibility (assuming this is represented by investor’s feeling or judgment about the news); in next day, the Fed said they would listen to the market and re-assess their rate hike decisions, reasonability pushed the market up, however, sensibility might diverge on the uncertainty: some people may consider this is a good news to the market, while other people may interpret that the Fed’s previous decision was more solid and therefore put more weight on that decision than on the re-assessment message which was forced out under pressure.

Now there are mainly three forces in the market: reasonability, pessimistic force within sensibility and optimistic force within sensibility. If we say sensibility provides more momentum to the market change than reasonability, which appears to be true, then the question is: how significant will the stronger force within sensibility effect the market change? This will determine the intensity of battle among these forces, and how the market level will change as a result.

Harnessing Reasonability and Sensibility

Reasonability is relatively easier to capture as we have developed sophisticated tools to collect data, conduct analysis and build advanced models/logics, but sensibility is not. While it is recognized that behaviour patterns can be referenced, nobody can firmly grasp the market pulse and place a similar degree of reliance on it to make predictions. This is because human mind can be so erratic and spontaneous on uncertainty that it is extremely difficult to estimate its trajectory, and even more difficult to get a sense of collective sensibility and its impact on the stock market.

Would there be some theories and tools to capture sensibility attribution to market change, and somehow harness synergy on reasonability and sensibility in the future? Perhaps. Before that time, I don’t have a good solution to generate profit. My only approach would be to reduce loss and protect principal by trading less during this tumultuous period.