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Risk Management

Process, Assumptions, Soundness

Every day investors and traders are presented with numerous charts and claims based on them. Understanding the process and assumptions behind the charts is crucial for determining whether the claims are sound or not.

Process is in some cases known: for example a 10-month moving average or a 14-period RSI. Understanding the process is important because if it is not known how the charts were generated, then one must accept only the soundness of the claims.

Assumptions are inherent in every claim in finance and in science in general. Some assumptions are evident but in many cases they are hidden. Selection of parameters for indicators is a form of assumption that some values work better than others. This may lead to over-fitting and spurious results.

Soundness is characterizes a valid argument with true premises. If the process or the assumptions are not known, then soundness cannot be established and accepting any claims is based on blind faith.

Examples

S&P 500 with 14-month RSI

This is a popular chart used frequently in financial blogosphere and media, usually by permabears who do not understand that RSI is a momentum indicator and any alignment with tops is only coincidental.

Process is known because 14-month RSI formula is known. Assumptions are not known because the reason of the selection of a 14-month RSI is not justified. Soundness cannot be established.  Any claims based on above chart must be accepted on blind faith.

Market Return Expectation

This is an indicator I developed to use as an example here instead of one of those presented in financial blogosphere to avoid perceptions of personal attacks.

I have fitted the parameters so that the indicator forecasts the 1987 crash, 2000 top and 2008 bottom.

Process is not known, assumptions are not known and therefore soundness of claims cannot be established. The above indicator is probably a spurious result of over-fitting.

S&P 500/CRB Ratio

Ratio charts of totally different indexes are random number generators but have been very popular and recently are all over the financial blogosphere due to the rebound in commodities.

I have no idea what conclusions one can derived from the above chart because is compares apples to oranges.

Process is known; it is the ratio of two indexes. However, the assumptions are not known and even those who present these charts maybe do not know them. Some may not even know the composition of CRB index. There is no way to determine the soundness of any claims made based on the above chart. One must probably employ an informal fallacy of “expertise” to accept the claims.

Process, Assumptions, Soundness. In most of the cases in financial blogosphere and media having to do with claims about the market based on indicators and charts, the last two are not known and in many cases all three are not known. Traders and investors should be very careful with charts involving claims that cannot be verified. Stock market investing and trading is also a game of bluffing.


Charting and backtesting program: Amibroker

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