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vanHow Your Brain Filters Who You Are

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One of my interests has always been how the brain works.  In fact, my extreme fascination with the brain led me to get a Ph.D. in Biological Psychology and my undergraduate studies were in psychology.   I was taught the behaviorism model of psychology which means that you try to understand behavior by studying patterns of stimulation and reinforcement (reward).   Doing so allows you to develop a set of rules that says “if you apply this form of stimulation, you get that sort of response.”  I wasn’t impressed when applying the behaviorism model to laboratory rats or later with the application to mentally-challenged children.  As a result, I decided I wanted to study the brain directly even though behaviorism was the predominant model in the early 70’s when I was working on my PhD.  

After I got my Ph.D., I began to study the science of modeling, NeuroLinguistic Programming or NLP for short.   Studying NLP was a big breakthrough for me because it gave me a format to model an area in which I was personally interested - all the processes related to investing including modeling 1) successful trading; 2) developing a trading system to fit you; 3) how to position size to meet your objectives; and even 4) how to achieve financial freedom by changing the rules of the money game.

One of the key presuppositions of NLP is “the map is not the territory.”   This really means that what you experience does not necessarily represent reality, it’s just a map of reality, although it might not be a good map.  For example, many of you have heard me say that you trade your beliefs about the markets, not the markets themselves.   Furthermore, your beliefs about the market may or may not be useful.   Most traders and investors, especially those who listen to the mainstream financial media, develop many beliefs which are non-useful and actually create problems in their trading/investing.  They don’t realize, however, how their constructed web of non-useful beliefs causes their problems rather than whomever or whatever they blame. 

Hopefully, most of you have read my latest book, Trading Beyond the Matrix.  If you have not, I believe it is my best book ever as well as well as my most comprehensive book.   The basic tenant of the book came from the sci-fi movie classic The Matrix.   Neo, the hero of the movie, is given a choice: take the red pill and see the world as it truly is, or take the blue pill and wake up in his bed to believe whatever he wants.  Neo, of course, takes the red pill, and the adventure begins.   Incidentally, we are currently running a contest on that book through the end of 2013, you can read about it here.

Trading Beyond the Matrix is based upon the presupposition that there is a real Matrix and a real red pill.  The book puts forth the idea that everything is illusion and that what we experience is the programming produced by our beliefs.  While this might sound extreme to some people, it also offers a lot of hope.  Why?  Because when you understand this idea, you can start to re-program yourself, like Neo, to operate within the Matrix at a super-human level.

I recently wrote a foreword to a book about the brain and investing in which I elaborated on how the brain creates the illusions that we experience.  I had actually considered writing a book about this area, to update myself, but once I had written the foreword I felt complete and decided that was all I would do for now.   The book recently came out, however, and I was shocked to see that my six page foreword had been cut down to two pages.   As a result, I thought I would include the material that had been cut from that book forward in this article in Tharp’s Thoughts. 

Much of what we now know about the brain has been discovered in the last 20 years.   That means that my education in the field, completed in 1975, is totally out of date.   It is also clear that there is now plenty of evidence to prove that the brain, through which we know reality, is not very kind in telling us what is really happening.

So, let’s look at several reasons why this is true. 

First, let’s look at some of the most obvious aspects of how the brain limits our experience through our sense organs. Let’s start with what we see.  Normally when we use the term "light," we are referring to a type of electromagnetic wave that stimulates the retina of our eyes. In this sense, we are referring to visible light, a small spectrum of the enormous range of frequencies of electromagnetic radiation. This visible light region consists of a spectrum of wavelengths that range from approximately 700 nanometers (abbreviated nm) to approximately 400 nm.  We can express the visible light spectrum in terms of meters, in which the range of wavelengths extends from 7 x 10-7 meter to 4 x 10-7 meter.    However, electromagnetic waves range from radio waves (low frequency) to gamma waves (high frequency).   The visible light spectrum is only a tiny portion of that.    The same is true for what we hear and feel.   We only sense a small portion of what’s out there, but through our brains we think that “what we see, hear, and feel is all there is.”  But that’s not true at all.   

Our brains are even more limiting than just what we experience through the senses.  For example, there is a section of the brain, the left parietal lobe, which gives you a sense that you are separate from the world.  This is a useful survival tool because when you think of yourself as separate, you can operate to ensure your survival.   And, of course, none of us survive for that long, so it also creates a lot of anxiety.

Notice how our sense of separation is now a function of the brain.   For example, if one could drop this sense of separation, then one might experience a sense of becoming one with the markets and seeing the market for exactly what it is doing right now without any sense of separation.   This is what is beginning to happen with traders who are waking up.   They can see the markets for what they are, rather than through the filters normally applied.

In addition, your brain keeps trying to stop the river of life from flowing because it is programmed to hold dynamic systems in place, to find fixed patterns in a variable world, and to construct permanent plans for changing conditions.   In other words, your brain is forever chasing after the past, trying to understand and control it.   The net result is that we experience pain as a sense that we cannot control or understand.  Furthermore, we miss seeing the markets for what they are.

You have an emotional system that causes you to react quickly to danger.  For example, one part of the brain, called the amygdala, sets up a general alarm system to galvanize you into action.   When your amygdala is active, you tend to either flee or fight.

For example, if you see something that looks like a snake, the first thing that happens is that a comparison device (the hippocampus) compares what you see with its list of things it knows are dangerous.  If it looks similar to anything on that list, it sends a message to the amygdala, you become emotionally charged and jump back.   It might just be a stick, but because it looks slightly like a snake you react as if it is one.   To protect you, your brain is responding to something that is not there.  

Your brain is primed to remember the most negative things that happen (a survival mechanism), but suddenly, you are responding to many negative things that are negative only because your brain tells you so.   Fear, for example, could easily stand for False Evidence Appearing Real.

chart1Fourth, you have a simulator in the brain.   Basically, it sees parts of reality and then fills in the pieces.  In fact, a branch of psychology, Gestalt Psychology, has been developed to study this phenomenon.    Look at the two diagrams in the figure to the left.   Between A and B you should see a triangle even though no triangle has been drawn.   This is because your brain fills in the pieces.   In the figure between C and D you see a sphere.   No sphere has been drawn, but your brain creates one.   This is an example of our simulator at work.

We are great at seeing—far better than the best computer vision systems yet devised, but that’s because the brain is so good at interpreting objects in our world.   The reason we’re so good at it is because of the simulator which makes things up.  Yet, when I talk about the brain having a simulator, I’m vastly simplifying what actually goes on. 

But this leads to another key point; we think we have a past and that our past is real.   After all, we have memories of what happened.   But in reality, the brain only stores bits and pieces of the past.   The rest is filled in by the brain’s simulator according to what seems appropriate for the context in which we are trying to use that information.

Let me give you several examples from my own past.   An old friend of mine works with the Van Tharp Institute. We originally met many years ago at a workshop and then again several times in a one-year period about ten years later.   Recently, she told her version of the story of how we met and it was completely different from mine.   Who was right?   Or were both of our stories fabrications of our brains?

Several times, I’ve written about my very first trade and how I made every mistake I possibly could in that trade.  You can read the full article about my experience or read the story here.  When I was 16, I studied the current issue of Fortune Magazine and learned about the stock that had the greatest earnings per share growth of any U.S. company.   It was a mobile home company called Poloron Products.   I bought the stock at $8.   As I remember it, the stock went up to $20, then it then fell back to $4 and I bought more.   It then went to $2 and I bought more and it then went to zero.   I was 16 in 1962 and I’m not sure how long it took for the stock to go from $8 to $20 to zero, but I would have guessed that it was 4-5 years.  I’ve always used that memory as a good example of how the notion of buy and hold does not work. 

For a number of years now, I have been trying to get a Poloron stock certificate and I finally found one recently on eBay for $5.   I was shocked to find out that the certificate was issued in 1983, almost 21 years after I thought I bought the stock.   Also, it was for 8 shares so it didn’t seem likely that anyone would have bought only 8 shares of a penny stock.   They would have paid less for it than I just paid for the worthless certificate.  As a result, I managed to get the data on the stock and was able to generate the following chart of its price behavior from the price that I remember that I bought it until it filed for bankruptcy.  

Chart2

 

You can imagine how shocked I was when I saw the chart.  Poloron didn’t reach $8 per share until 1967 when I was in college (unless this chart shows a stock price that may have split several times) which makes some of the observations from my memory even worse.   I wasn’t thinking about the stock market in 1967 that I know of.

In addition, Poloron went to $37 per share, not $20, around 1970.   At this point I was just getting out of the Army and I certainly wasn’t looking at the stock market.   Again, it could be split adjusted, but $37 is already nearly twice what I remember the high being.  By 1970, if my memory was correct, I didn’t even know where the stock certificate was and it may have been lost.  And if I bought more at $4 and at $2, it was while I was in graduate school.   I was trading in graduate school, but not Poloron.   If this chart is correct, the price actually recovered to almost $5 a share in 1976, before going bankrupt in 1981.  And finally, why was my stock certificate for 8 shares issued in 1983 when the stock was already bankrupt?

Anyway, over the last 30 years, I’ve told my Poloron story the same way many, many times—about how I did my research and watched the stock go from $8 to $20 and then to zero.  If this chart is right, though, there is very little about my memory of the trade that was accurate.   And the mistakes I made may have been even bigger than I thought, including thinking that the stock was bankrupt and losing certificates for 300 shares of stock that had value through 1981 (in those days, the broker sent you the shares of the stock you purchased).

Even though your brain is a fabricator of reality, you must interact with the market using your brain.   You create your reality by using your brain to give meaning, form beliefs and make judgments.  

When you see a market chart, you are really seeing a representation of billions of ticks of movement in various trading instruments.  You look at a chart in an attempt to make sense of the market by using price bars to represent a particular time period — whether that’s a 5 minute candlestick or a monthly bar.  When you do this, you have simplified (distorted) reality but now, perhaps this simplification of the market still doesn’t make sense to you.  As a result, you distort reality even more by transforming price bars into various technical indicators such as moving averages, momentum indicators and divergences.   Other people decide to gather fundamental data and they give meaning to that information.  All you are doing is trying to make sense of the market, and yet the more you try, the more you distort reality.  

This is why I recommend that you “wake up” to the Matrix and see how you are distorting reality.   When you do, you can begin to see the markets for what they are.   And when you do that, you can easily find statistically sound, low-risk trading ideas.   

About the Author: Trading coach and author Van K. Tharp, Ph.D. is widely recognized for his best-selling books and outstanding Peak Performance Home Study Program—a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.vantharp.com. His newest book, Trading Beyond The Matrix, is available now at matrix.vantharp.com.


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DRShorting an Empire: Part III

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There won’t be any China dignitaries coming at you this week (we’ll save that for another week) — Just some numbers; some scary numbers.

Over the past few weeks, we’ve been looking at why some smart folks, notably renowned hedge fund manager and shorting specialist Jim Chanos, are getting bearish on China.

When we talked about Chanos’ short position on China a few weeks ago, we mentioned the credit bubble that is fueling the country’s fixed investment growth.  Today, we dig into some issues with Chinese credit and look at why Fitch ratings recently downgraded the country’s debt.

Lending Like It’s 2007

Fitch is one of the big three rating agencies and it put some numbers behind its concerns.  The first set of numbers comes from the big picture of Chinese national debt growth.  Since the Lehman crisis rocked the U.S. and global credit markets, credit in China has expanded an amazing 2.5 times — from $9 trillion to $23 trillion.  In an interview with The Daily Telegraph,  Fitch’s senior director in Beijing, Charlene Chu, was quoted as saying that with China’s rapid debt expansion, “They have replicated (the excesses) of the entire U.S. commercial banking system in five years.”

In the five years leading up to the U.S. credit crisis in 2007, the ratio of credit to GDP rose 40 percent.  Similarly, Japan’s same ratio expanded a similar 40 percent in the five years preceding the Nikkei bubble that burst in 1990. 

What’s frightening is that China’s ratio of credit to GDP over the past five years has swelled by 75 percent, almost double the rate that has proved unsustainable in two prior bubbles.  Ms. Chu continues, “This is beyond anything we have ever seen before in a large economy. We don't know how this will play out. The next six months will be crucial."

Even Scarier — The Shadow Banking System

By current traditional banking debt standards, the non-performing loan rate in China is around one percent — a figure that raises no eyebrows.  In its explanation of the downgrade, however, Fitch warned that China’s shadow banking system allows the banks to circumvent loan restrictions and sidestep regulator's efforts to slow down the runaway lending.  The banks’ second balance sheets also allow them to hide an estimated $2 trillion worth of lending.

Given this huge chunk of off-balance-sheet assets, Ms. Chu says of the Chinese banks’ low non-performing loan rates “. . . mean nothing if you can off-load any bad asset you want. A lot of the banking exposure to property is not booked as property." 

China’s shadow banking system also leads to nightmares for ratings agencies and investors who want to understand the relative health of the financial system.  Ms. Chu weighs in again, "There is no transparency in the shadow banking system and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signaling."  And in a Chinese economy that continues to fuel growth through rampant lending, Fitch reports that more than 50% of new credit being extended in China is coming from the shadow banking system.

The near-term concerns coming from China’s shadow banking system should sound eerily familiar.  One of the problems that punctured the U.S. credit bubble was the large variety of mortgage-backed securities that were being repackaged and financed using short-term rate instruments.  When those 90 or 180-day rates popped up, whole tranches of derivatives defaulted.  And in China’s shadow banking system, 50 percent of the loans have to be rolled every three months and another quarter of the loans need to be rolled six months.  The first real upset we see in Chinese credit markets could literally freeze the system.

Tune in next week when we dig deeper into the financial situation of the Middle Kingdom.  Until then, your thoughts and comments are welcome—please send them to drbarton “at” vantharp.com

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

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August 21, 2013 #643

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