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Statistical Mistakes Traders Make

Doc Steenbarger has an interesting discussion about one the most common mistakes traders make: They confuse descriptive statistics with inferential ones:

"Much of the information that traders work with is descriptive in nature. Consider these statements:

* The market trendline is up;
* Advancing stocks are ahead of declining stocks by 2:1;
* We are making new weekly highs in the market;
* Volatility is at a new monthly low;
* The market made a breakout from the trading range.

All of these are descriptive. They take a sample from a price or indicator series and describe characteristics of that sample.

The intermediate step between observation of descriptive stats and a hypothesis of inferential ones is backtesting:

"Descriptive statistics can lead us to the formulation of hypotheses, but they cannot provide tests of those hypotheses. That is the role of inferential statistics. To test a hypothesis, we must evaluate multiple samples and verify the existence of suspected patterns.

The quantitative, system trader trades patterns that have been tested with inferential statistics. The discretionary trader trades descriptive hypotheses that he/she validates with updated, real-time readings of market conditions. Is the discretionary trader justified in doing that? The same inferential tests that inform us of the validity of trading systems, when applied to the trader's trading results, will answer that question."

There are numberous ways to backtest theories and trading hypotheses:  Trader DNA evaluate trader performance metrics; On a broader level, firms like Clarifi can backtest entire quantitative market strategies.

Regardless of the level of analysis you may be working with, this leads to an obvious but overlooked question:  Whta have you done to qualify or test your trading or investing strategy?

That is one of the reasons I respect pure value investors: It may be somewhat boring and require  immense patience, but it has been thoroughly vetted and tested as an investment methodology.

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Source:
The Most Common Mistake Traders Make 
Brett Steenbarger    
TraderFeed, Thursday, September 14, 2006                       http://traderfeed.blogspot.com/2006/09/most-common-mistake-traders-make.html

Sunday, September 17, 2006 | 07:29 AM | Permalink | Comments (16) | TrackBack (1)
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