Month: October 2012

Economics Is Social Science

Many people confuse economics as a science like physics or medical science. Economics is part of social science. It is not the kind of science that can produce precise projection or accurate forecast . In this sense, most of the theories you have come to hear about in economics have no practical value in trading. If cars are made by economists with their economic theories, the cars will explode and burn the moment you drive them, even though the car never moved.

Financial Economics takes the nonsense one step further. As all human with any common sense know, the price of anything that is determined through market mechanism is controlled by the buyers and sellers. They can do whatever they want but their actions are mainly goal driven. The goal for any normal participant in a market is to make money. Yet economists assume price movement in our markets to be random without even checking if reality matches their assumption at all. When the most fundamental component in the study of financial economics, price movement, is not even properly examined at all, how can anyone believe it has any practical value?

Economics Is Alchemy In Its Present Form

With this understanding, it is no surprise that predictions and projections generated under the labels of the above disciplines are always contradictory among its practitioners. There is almost always no agreement among economists where the stock markets is heading. Financial analysts almost always giving completely diverged opinions where a stock is heading. And worst of all, these supposed leaders in the field of economics all failed to tell that the 2008 financial crisis was going to happen.

One has to realize that economics, in its present form, is no different from alchemy. Many of these so call economists or analysts are just very bad alchemists. They do not really know what they are doing. They just guess, imagine, and b#llsh*t to make their livings. All kinds of theories with all sort of bizarre analysis techniques are invented by these guys – from collecting economic data, studying corporate financial statements, to analyzing historical prices. These techniques, often borrowed from other scientific disciplines, are created to see if they can explain what happens in a market or economy as a whole. Due to the origin of these techniques, these analysis look so complicated that people assume they are legit. No, they are not because these fancy things cannot produce consistent results that match what happen in the real world.

Outside of the academia, there are very good analysis techniques developed over the years by people whom are affected most by the markets – the participants like traders and market makers. These techniques focuses on what matters most – where price is likely going. An interesting fact about these techniques is that they are practical. Their work (or trading methods) do not have fancy theories behind so there is no glamour nor talking point in parties. What these trading methods offer are consistent trading results that enable these participants to stay profitable in the markets year after year.

During Medieval Times, those alchemists who figured out how to determine the metal content in the ores, or those who figured out how to extract metals from the ores, would keep the techniques to themselves so that they could serve the powerful warlords. They might not fully understand what they were doing (and in our eyes they might actually get the concepts completely messed up). But the most important thing was that these individuals had developed repeatable processes and methods which produced consistent results.

See the parallel there?

Alchemy Is Not All Bad

For western alchemy, most of it was eventually purged and disappeared. Some part of alchemy that works becomes the foundation of modern chemistry. Process like distillation was invented by alchemists. Those bad alchemists who did voodoo things and boost magic theories are now condemned forever in history. Those alchemists who did actual investigative work with scientific (or practical) mindset leaving us with useful knowledge are praised as pioneers in modern science.

The good sign is that we are seeing improvements in the study of economics in recent years. Academics finally succumb to their failures as they are ridiculed by not just the more successful market participants but also the public in general how stupid and useless they are. The younger generations of economists have started questioning the foundation of the accepted theories in economics. New branches like behaviour economics tackle the concepts of economics from a different angle and has been showing a lot of promises.

Economic Theories And Trading Don’t Mix

Understanding the limitation of economic theories in its present form tells you how dangerous it is to shape your trading ideas from these concepts. I know it is difficult to put a block in your head to separate your trader self from your economist self (don’t we all having an opinion where the economy is going?) but it has to be done.  Do not make any financial decisions based on just big picture ideas because that will definitely hurt your bottom line.

Remember the main reason why economic theories fail in reality is that they do not produce precise projections into the future.

The predictions made by well-known economists are doing worse than the weather forecast you get daily from your local weather man. If these "experts" in economics cannot produce consistent forecast with their expertise, how can you expect to do anything useful with their theories?

Results Oriented Thinking

Then what tools should we use in trading or making financial decisions?

The various methods people are using right now that has been producing consistent results.

Make no mistakes, these methods, be that chart reading, market breadth analysis, or tape reading, are also a form of alchemy.

Comparing to accepted economic theories that always fail to forecast anything correctly, some of these methods and techniques are showing consistencies in their ability to produce better trading and projection results. These are the good methods just like the good alchemy stuff. Even though we may not know the underlying reasons why these techniques work, as long as they are producing consistent results, it makes more sense to use them over the inferior economic theories.

You know these techniques are far from perfect. In fact, you know most of them are borderline alchemy stuff. Hence, you use them in your trading decision process only after you carefully experiment with the methods (i.e. backtesting and/or manual chart verification depending on your preference) and can confirm that you can get good results.

Techniques that are not giving you consistent results should be dropped.

Most important of all, never trust a trading method 100% even though it has been working well for you over a long period of time. As traders, not only that we do not marry to our positions, we do not marry to the trading methods as well.

p.s. "An economist is someone who doesn’t know what he’s talking about – and make you feel it’s your fault."