Imagine you are part of a group of 100 participants playing a game for a cash prize.
The aim of the game is to guess a number between 0 and 100, and the winner is the one who picks the number that is closest to two-thirds of the average number.
What number would you pick?
Make your choice now, and don’t proceed until you’ve done so.
(Play along! It will be fun and perhaps even educational).
Let’s see how you did.
If you picked…
Any number larger than 66
Sorry, you either didn’t understand the rules of the game, or you really didn’t think this one through.
Since the largest possible winning number is 66 (two-thirds of 100), you’ve picked a number that automatically disqualifies you from the cash prize.
You presumed that the other participants would randomly pick a number, which would average out to 50.
However, two-thirds of 50 is 33. So you either forgot about the two-thirds part, or you didn’t think this though.
Either way, you’re unlikely to win the cash prize.
Now we’re getting somewhere. You presumed most of the participants are idiots and would randomly pick numbers (which would average out to 50), and multiplied that by two-thirds to get 33.
This is the number most people pick.
You realize that most of the participants would assume that everyone else are idiots, and so picked a number that is two-thirds of the number they would pick (two-thirds of 33).
But wait… you realize that there are people who realize that other people think that everyone else are idiots.
And so on…
If the participants in this game were purely rational, the theoretical winning number would be either 0 or 1 (long story).
In practice however, the winning number tends to be 22.
Theory Of Mind
This game is related to the philosophical/psychological hypothesis called the Theory of Mind.
Wikipedia describes it as “the ability to… understand that others have beliefs, desires and intentions that are different from one’s own.”
To win at this game, you would have to correctly guess what the other participants are thinking.
Their “beliefs, desires and intentions” determine the number you should pick.
Trading Works The Same Way
It is commonly believed that the market is driven by economic fundamentals and/or technical analysis.
But in reality, it is actually the market participants’ reaction to those factors that causes the price to move.
See a moving average crossover? Well, so do many other traders. If you took a trade based on it, who exactly are you counting on to push the market price in your direction?
Where The Battle Is Fought
This is why I keep saying that trading systems based solely on technical indicators don’t work.
By focusing on technical indicators, a trader ignores the most important factor: his competition. He has no idea of even who that is.
You see, the game of trading is not played out on a trading chart, but in the participants’ minds.
The only way to make money in trading is upon the current, or future losses of other traders.
So any strategy that fails to account for the thoughts and actions of the competition is practically useless.
Perhaps, this is what Warren Buffet meant when he says he likes to be greedy when others are fearful.