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Cook`s Kitchen

A member of my Market Timer trading service wrote to me recently to express his frustration. Essentially, he was confused by the multiple sources of competing research I would cite in my commentaries. In particular, he wanted to know why would I share bearish research when I was so darn bullish!

Two words: confirmation bias. This is the tendency to see and seek primarily the facts and evidence which support our beliefs and positions. Let me give you some background on why getting past this bias is so important to me, and why it should be to you too.

School of the Markets

As a short-term futures trader 15 years ago, I had to spend a great deal of time studying two areas besides charts. Probability and behavioral finance became passionate areas of self-education, with a little bit of brain science blended in.

Why the behavioral and brain stuff? Because as any experienced investor-trader will tell you, we are always our own worst enemy in the markets. Understanding how your brain actually works from the psychologists and the neuroscientists can reap invaluable insight and rewards when it comes to dealing with money and risk.

Because as both groups of scientists will tell you, the evidence is overwhelmingly in the camp that we are naturally irrational when it comes to making solid, long-term and short-term decisions with money and risk. (Hint: our beliefs and emotions are almost always in the way even when we think they are not).

What was so fascinating to me as I absorbed all this new knowledge is that the Chicago trading pits at the CME and CBOT were full of wile market veterans who already knew this stuff intuitively. Or, I should say, they earned it the hard way in the pits through lots of trial and error (losses and tears).

In 2005, I wrote a long paper titled "Your Brain Wasn't Made to Trade" to share the best of the research from both fields, that smart traders already knew. Part of it was published in SFO Magazine in 2008 under the title "Mental Models of Financial Sabotage."

Scenarios & Probabilities

To this day, I can think of no better way to check my biases -- and my emotions -- than to read lots of competing research -- especially from the bears when I am extra bullish. I have a list of over a dozen institutional bears I try to keep up with currently.

Doing so can often fortify my case, as if I can say, "Is that all he or she is worried about?"

And it can often get me to dig further, potentially reevaluate my stance, and consequently adjust my strategy and positioning.

What's the danger of staying stuck in your biases? Just ask anybody who has been short the market this year. I am not gloating because I have been there plenty of times myself, on the wrong side of the market and clinging to my ideas.

But if I think in terms of probabilities and always assign a 20-25% probability to the opposite side of the Bull-Bear coin, then I force myself to keep actively pursuing research in that vein.

Edge/Odds

This habit actually reinforces the strength of my current odds and analysis. Even if you are an excellent stock researcher and picker, you know that the market and sectors can be a big determinant of your success. So you will use the Zacks Rank but also look at the industry and the market as a whole to put the odds increasingly in your favor.

Since I bet primarily on indexes and sectors with Market Timer, I must have a clear plan to know where and when to increase or reduce my bet size. This is "probability and risk 101" that lots of traders learned from teachers like Ed Thorp of Beat the Dealer fame.

Thorp's 1962 book was the first to mathematically prove that the house advantage in blackjack could be overcome by card counting. He carried this knowledge into financial markets with his hedge fund, Princeton-Newport Partners, which boasted a 15% annualized return over 19 years.

Thorp taught the basic relationship of "edge/odds" to gamblers and investors, which he learned from a 1956 paper by John Kelly of Bell Labs. Popularly known as the Kelly Criterion, the simple idea is to divide what you think you could win (edge) by what the horse track/poker pot/market says, or implies, you could win (odds).

This tells you how much -- essentially, what fraction -- of your "bankroll" to bet. Edge is similar to "margin of safety." And though the stock market doesn't hand you guaranteed odds, we are accustomed to assigning a risk level to every investment or trade that almost gets us there. In the end, we have to be comfortable with the risk, or we don't like the odds.

In a nutshell, edge/odds could be used to answer these types of questions:

What do you "know" (or believe) that the market doesn't know and is therefore currently undervaluing about a stock or an index?

What stocks and sectors will benefit most from economic trends or institutional money movement?

Where will P/E multiples go if things happen with data, price, and news that the market is currently not factoring in?

Built into the Kelly Criterion are the goals of compound return and never accepting even a small risk of losing everything. Even though it is a very aggressive betting formula, it can obviously be diluted and customized to one's risk tolerance and so the concept is what's really important here.

Where Will the Money Flow?

We don't have time here to get into the details of how to apply what is primarily a betting philosophy to the stock market, but the basic mechanics of "edge/odds" are used by many portfolio managers to concentrate success even as they diversify across stocks, sectors, and market correlations.

More than anything, it is a way of thinking about risk/reward and how information of various levels of importance can be used to adjust your exposure.

I just wanted to share the basic idea that you must have a plan for everything from stock-picking to index/sector allocations and their weights (bet size). And when you inform your plan with a broad swath of information -- even the kind that challenges your biases -- you end up with a flexible approach that can adapt.

Instead of overreacting to market swings, you already had that scenario in mind and knew what you would do if it surfaced.

And where this comes in most handy is when you catch big swings in the market that most weren't expecting, ideally allowing you to buy and sell at great levels near turning points.

Are we at a major turning point on this day March 8, 2012 with the Dow and the Russell 2000 yet again making new all-time highs? I don't think so. Earlier this week I decided that the next 40 point move from S&P 1540 would be up, not down, with about a 65% probability, as it seems that institutions are still underexposed to equities and, therefore, their risk is to the upside.

So I position and bet accordingly in the rally that still seems unbelievable to many.

As my one of my favorite poker players sums up the key to his success, "When you get the best of it, make the most it."

Kevin Cook is a Senior Stock Strategist with Zacks.com

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