
I am grateful to Nobel Prize winner, Daniel Kahneman, for the phrase
“The illusion of validity”. I am also grateful to him for writing a very
readable book that explains what it means, along with many other things of relevance
to all aspects of life, but especially to those of us who wish to be successful
traders. The book is called “Thinking, Fast and Slow”. It is available on
Amazon, here.
Kahneman’s reference to validity is about nothing more or less than the
existence of even the possibility to make accurate predictions in the environment
in which the aspiring predictor operates, never mind the ability or otherwise of
individuals to operate effectively within that setting.
He says:
“When do judgements reflect true expertise? When do
they display an illusion of validity? The answer comes from the two basic
conditions for acquiring a skill:
- An environment that is sufficiently regular to be predictable
- An opportunity to learn these regularities through prolonged
practice
When both these conditions are satisfied, intuitions
are likely to be skilled. Chess is an extreme example of a regular environment …
Physicians, nurses, athletes, and fire-fighters also face complex but
fundamentally orderly situations … In contrast, stock pickers and political
scientists who make long-term forecasts operate in a zero-validity environment.
Their failures reflect the basic unpredictability of the events that they try
to forecast”.
It is of some interest that Hahneman mentions
stock-picking, as this not too far away from what we are concerned with, the
trading of Foreign Exchange pairs. For a long time now, we have been saying
that it is fundamentally impossible to foretell the future. We have also used
Chaos Theory, as propounded by Edward Lorenz, where we likened making
predictions in trading to forecasting the weather. The ability to think in
probabilities has everything to do with both of these.
Kahneman goes further than Lorenz, however, as
he points us in the direction of how we can improve the situation: In order to
prevail, “all” we have to do is to figure out what is required to make the environment
of FX trading more valid, according to his definition.
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