The Mean Reversion Heuristic

You do not need to be a brain surgeon to successfully trade stocks.

In fact, if you gave me the choice of which was more important, intelligence or cognitive flexibility, I would take the latter every time.

Here’s why.

The world around us is filled with instances in which things tend to revert to the mean.

If I flip a coin 100 times and happen to get 90 tails and 10 heads, chances are that the next 100 flips will wind up closer to 50-50.

In nature, most times in which outlier events occur, subsequent events move us back towards the mean.

As a result, humans have this natural tendency to expect mean reversion and to make judgments in accordance with their expectations.

This mean reversion heuristic in and of itself is not irrational and actually serves a useful function most of the time as it saves us the energy of having to make complex calculations in our head. It serves as an efficient mental short cut.

However, it can get us into trouble when we are trading markets.

Over shorter and even intermediate time periods, markets do not necessarily revert. In fact, some of the very best trading situations occur when an asset is strongly trending or when the reversion time frame is so long that it is inconsequential to the current trade or even the next dozen.

This is why traders often have a hard time buying stocks that have already moved higher or are making all time highs. The innate expectancy mean reversion heuristic voice pops up in the back of one’s head whispering, “its moved so far, it must revert, that is just nature.”

So, give me someone who can adapt, someone who is flexible over someone who is a rocket scientist any day because I can teach him to ignore that voice inside his head telling him that break outs must revert.

The mean reversion heuristic is just one more example of how conventional thinking styles that come hard wired in most of us and which serve us just fine in most environments require suspension in the trading turret.

I will speak at length on this topic tonight on Market Shrinkology at 9:30ET on StockTwitsTV.