In-depth Analysis

Keep it Simple, Stupid

 

This sentence, which is often summarised as KISS has been one of my guiding principles for almost 20 years. 

After all when you are trying to make sense of the markets and why they move the way they do, it’s all too easy to overcomplicate things. That’s true whether you are drawing a chart, looking at a recently released economic data point, or making a prediction about where the dollar is headed over the next 6 months.

Consider these two charts 

They both feature the US stock PayPal (PYPL) whose share price has been moving recently for a variety of reasons. Both charts contain the price action and indicators. I don’t know about you but I find it much easier to extract information from the simpler of the two charts, that is the one below, a line chart with the stock’s 50-day moving average drawn over a three-month period.

We can clearly see the point at which the stock started to move higher in early July and when it broke back above its 50-day moving average, which was a potential buy signal all of its own. 

The move above the 50-day line was confirmed later in July when the price tested back below the line and rejected that move lower. The inference from that, being that if the price isn’t going down then the path of least resistance is likely to be upward.

If ain’t broke don’t fix it 

A concept that is often used in detective stories and thrillers is also highly relevant to decision-making in the financial markets. And that is Occam’s razor, which is named after its inventor the 14th-century monk and philosopher William of Occam. The basic premise of the razor is the idea that the simplest solution to a problem is likely to be the correct one. 

Solutions that are over complex and contain too many variables are unlikely to be correct because the more factors that are involved in the decision-making process the less likely those factors are to line up at the same time.

In a recent research note and blog piece. Joachim Klement, the head of strategy at UK Investment bank  Liberum, cautioned about becoming what’s known as a busy fool. 

A phrase that was coined by one of his colleagues to describe people who fall into the trap of believing that having more data about a market or investment means that you will be better able to forecast what happens next to that instrument’s price. 

When in fact the reverse may actually be true because eventually, you get to a point where you can’t see the wood for the trees- this situation is often described as paralysis by analysis. In other words, you are overwhelmed by data and other inputs, and unable to make a decision.

Financial markets are not the only thing that needs forecasting and contain thousands of variables. One obvious example is the weather and meteorologists can provide us with clues about how to do this. 

The weathermen use high-powered computers to run through hundreds and sometimes thousands of varying scenarios, to see how the weather is going to evolve over a given period. 

Of course, they end up with hundreds of possible outcomes however they discard the majority of these and focus instead on the most common outcomes because they are the most likely to occur.

Variables in the financial markets can be condensed into a handful of simple factors which are supply and demand, and greed and fear. Price formation is the process by which these factors come to a state of equilibrium, it is at that point buyers and sellers can transact with each other. Something we will look at in more detail in a future article.

 

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