When Genius Failed (Roger Lowenstein) #2

There is a reason why financial markets run to extremes more often than coin flips. A key condition of random events is that each new flip is independent of the previous one. The coin doesn’t remember that it landed on tails three times in a row; the odds on the fourth flip are still fifty-fifty.

But markets have memories. Sometimes a trend will continue just because traders expect (or fear) that it will. Investors may slavishly follow the trend for no other reason than that they think enough others will do likewise. Such momentum trading has nothing to do with logically appraising securities; it doesn’t fit the ideal of rational investors in efficient markets. But it’s human. After three bad “flips” in the market, the fourth flip may no longer be completely random. Some traders may have taken losses and be forced to sell; other investors, looking over their shoulders, may panic and decide to beat them to it—as happened with Treasury bonds during Long-Term’s inaugural spring.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: