During my currency trading career, three books have had a profound influence on me by dispelling several common beliefs. And perhaps they can help you too.

The first was ...

The Way of the Dollar, by John Percival

With this introduction, Mr. Percival made a key point that struck me:

"Finally one had to see if there were other relationships which had any predictive value for currencies — like inflation, trade, money supply, oil prices, economic growth, et al.

"So far, the conclusion is that few such relationships — and none of the relationships that most observers seem to rely on — are useful for predicting the dollar."

It took a while for Mr. Percival's early lesson to sink in. In fact I still make the mistake of looking for factors where none really exist. I think this is an area where many other investors make the same mistake. I often receive e-mails telling me the dollar can never rally or things can't happen because of A-B-C ... the relationship is "perfectly clear."

The favorite rationale I hear most is about debt. Granted debt is a serious problem and not one to be taken lightly by any means. When it comes to currencies, though, over time there is very little correlation between debt and the movement in the dollar, or many other currencies for that matter.

But it seems people latch on to ideas they cannot let go of. And the degree to which they cling to these beliefs in financial markets is unusually strong.

Just look at the debt profile of Japan. The yen has gone up and down a lot during a period when debt levels as a percentage of GDP have consistently soared!

Next is the best book ever written about global macro investing ...

Alchemy of Finance, by George Soros

Who better to learn from than the single best global macro trader ever?

In this brilliant treatise on the subject, Soros said strange things, such as:

"There is no such thing as 'equilibrium.'"

"Asset markets are nothing more than "boom-bust cycles."

"Prices are fractal in nature."

Then in Soros' book I stumbled across the name Karl Popper, a German philosopher, who wrote ...

Problem of Induction

Induction's application in the financial world is best known as "back testing." This is what you get when you assume that what happens in the past will happen in the future. Such an assumption can be deadly dangerous to a trading account.

Reading Popper gives a deeper understanding of why we cling to beliefs so tightly and assume we can confidently project our expectations into the future and be confident we will be right.

Sometimes I'm asked: "Why are you so confident that x, y, or z will happen?"

I am never fully confident, although in a high enough degree to pull the trigger. So I provide some rationales, knowing that the market can prove them wrong at any instant. Reading Popper should come with a warning label, as he will do that to you.

Popper asked the following psychological question: Why do we all have expectations, and why do we hold on to them with such great confidence, or such strong belief?

He posed that we must use experience of past instances to advance our knowledge. But we must accept the fact that just because so many past instances were effectively consistent, or the same, it doesn't mean a theory based upon those past instances has been proven.

The reason he says this is because there may be some future instance out there that invalidates all that has come before it, and it only takes one such instance to do that. Therefore, all theories can be falsified, but they cannot be proven simply by past experience.

Examples: Everyone knew AAA-rated securities were safe. Everyone knows municipal bonds will be fine because the default rate has always been low in the past. Everyone knows that gold is the only real money. Everyone knows inflation is a monetary phenomenon. Everyone knows the dollar must go down. Everyone knows thatChina will rule the world soon.

We could go on and on with what everyone thinks they know. But interestingly, the things we seem to think we know often don't even have the consistent instances of induction in their favor!

We cling to ideas in the financial world that have been falsified before but seem to gather a second life. This isn't even close to the wordlogical.

I think this is why the kernels in financial markets seem to be centered on the understanding that markets are driven by irrational expectations; therefore sentiment is where one should maintain focus.

Now back to Percival, again from his introduction to The Way of the Dollar:

Because the system's constituent parts are mostly based on human behavior which doesn't change, we can be confident it will continue to work.

The financial markets, as anyone familiar with them knows, have a logic of their own, which is in a way the opposite of normal logic. Hence the market adage 'sell on the news' applies to good news not bad news. Hence other bits of market lore like 'a bull market climbs a wall of worry: A bear market flows down a river of hope.'

Markets do whatever they need to do to confound the greatest number of people.

This happens because prices reflect expectations. If everyone expects unemployment to rise, or a trade balance to fall, or inflation to remain steady, there is no intrinsic reason why they should be wrong: The expectation doesn't affect the outcome.

But if everyone expects shares to fall, or the dollar to rise, there is every reason why they should be wrong: Because current share price levels already reflect the expectations of lower prices, and the current level of the dollar already discounts a rise.

In other words, the expectation cancels the outcome.

You can see why Mr. John Percival is an excellent mentor. One more interesting thing Mr. Percival wrote in his book, which he later said he wished he left out was this:

"Active traders have little to lose and much to gain by observing the following maxim: Distrust price action ahead of a full moon, trust the action after it.

"Rationalize it as you please: The impression is that market action tends to be primitive, dim, and emotional before full moons, and more collected and rational after them; and that there is sometimes a periodicity in currency fluctuations which can be almost as reliable as the tide!"

Loony sounding I know, but there is a key point we shouldn't miss here ...

Successful trading is not about being a genius, but about constantly exploiting 'the little edge.'

In short, we all can and should have reasons and rationales in our mind about why we have taken our positions. We need that confidence to push us over the edge so we can take a position in the first place, i.e. pull the trigger.

But we must understand that our beliefs can be destroyed by the market at any moment. And that moment usually happens when we too fervently argue said beliefs.

Source: moneyandmarkets.com

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