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Friday, August 04, 2006

Increasing or Decreasing Probabilities

People think in two ways to reach a conclusion: inductive and deductive reasoning. An example of inductive reasoning is "seeing" the sun rtise in the east everyday thus concluding that the sun always rises in the east. An example of dedcutive reasoning would be knowing the fact that the earth rotates on its axis from west to east therefore concluding that the sun rises from east to west.

Let's say you are put blindfolded on a train running at 120 kph with no working breaks.

As you sit there you begin to think of what will happen. If you use inductive reasoning, the longer you sit there the more you are convinced that the train will not crash because it hasn't yet. You think the probabilities are decreasing that the train will crash.

How about using the deductive approach? The train is moving fast. The track is not infinite. Since you know the only thing that will stop the train is a crash, you conclude that the probabilities of the train crashing soon are increasing.

The two methods come to exact opposite conclusions.

I think too many traders/investors use inductive reasoning when approaching the markets. They are fooled into wrong conclusions because they are conditiioned to. Behavior is re-enforced even though that reinforcement is actually changing the odds in exactly the opposite way.

We can use this argument on the effect of growing debt on the US economy and its effect on asset prices. Total debt in the U.S. is now over three times GDP. Inductive reasoning tells many people that since nothing bad has happened to asset prices, the probabilities are decreasing that they ever will.

Deductive reasoning tells us that, by definition, there has to be a level of debt that will eventually curtail consumption and that since debt is growing, the US is getting closer to the point that high debt will curtail consumption.

Scientific evidence and history have shown people are more prone to being inductive than deductive. This is the root cause of herd mentality.

Choo choo choo...

Thanks to John Succo for the idea.

Paolo

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