Street Smarts Beat Book Smarts In Trading? (Occam’s Razor in trading)
Last Updated on April 18, 2023
You want to be a street smart trader: being street smart is much more important than being book smart. Why is being street smart more important than being book smart?
Trading is much about common sense and heuristics. Street smarts beat book smarts in trading because street smarts don’t make it more complicated than necessary. Occam’s Razor states that the most simple answer is normally the best answer, and street smarts use heuristics and Occam’s Razor all the time.
Yes, I know it works in practice, but does it work in theory?
We believe street smart traders stand a better chance of succeeding in the markets than book smarts, although some elements from both are probably optimal.
Because quant trading requires creativity, innovation, and experience, much more so than technical or academic skills. Technical skills don’t automatically result in alpha. Likewise, youth doesn’t guarantee creativity, flexibility, or innovation.
Fat Tony and Dr. John by Nassim Nicholas Taleb
Nassim Nicholas Taleb has its fans and enemies (we are mostly fans and highly intrigued by his books which we strongly recommend). In one of his books, we believe it is The Black Swan, Taleb mentions a toss coin involving Fat Tony from Brooklyn and Dr. John, a rational and logical academic:
Fat Tony is loud, perhaps a bit careless, shrewd, and lives by heuristics and his wits. He is a typical street smart.
Opposite, Dr. John is careful, detail-oriented, meticulous, logical, rational, and very intelligent. Dr. John is a typical example of someone who is book smart.
Both Fat Tony and Dr. John make mistakes, but usually very different ones as will be shown below.
Taleb uses a coin toss to separate the distinction between the two gentlemen’s mindsets:
Assume that a coin is fair, i.e., has an equal probability of coming up heads or tails when flipped. I flip it ninety-nine times and get heads each time. What are the odds of my getting tails on my next throw?
Dr. John answers, of course, that this is simple and trivial. The correct answer is 50% as each toss is independent of the last one. What else could it be?
Fat Tony begs to differ: No way it’s 50-50 chance of heads or tails, the game is rigged. At best there is a 1% chance of getting tails on the next throw as the coin is loaded!
Street smart vs. book smart traders
The academic environment puts a lot of emphasis on books and classes, while “street smartness” only can be developed by trial and error in the real world (common sense prevails).
We can argue that the two mindsets differ significantly in how they operate and work. The academic world is based on structure, logic, and rationality.
However, the real world is often light-years away from academic theories. The world is not rational, bell-curved, or structured. It’s complex and difficult to understand. Models can’t capture how the world operates. The financial markets are non-stationary and correlations change all the time.
Theories can’t explain behavior, there is risk asymmetry, information overload, and experience often trumps what you learned in an organized classroom.
Success in the street is something different than success in the academic world. Is high IQ an advantage when you are setting up a new venture? A new venture is always based on risk and incomplete information. It’s a lot about gut feel. Street smarts often rely on their guts and intuitions to guide them, while book smarts rely on surveys and rational explanations.
Trading is all about incomplete information and making decisions on an uncertain future. This brings us to Occam’s Razor:
Trading and Occam’s Razor
William of Ockham was a monk who lived in the 1200s. He stated that problem-solving should be simple and done with as few variables as possible. His conclusions have since become what is called Occam’s Razor:
The simplest explanation is usually the best one. Other things being equal, simpler explanations are generally better than more complex ones.
We should always select the hypotheses with the fewest assumptions!
This applies to trading: You should always use simple strategies with the fewest variables and assumptions.
We believe street smarts are more likely to use Occam’s Razor and heuristics in decision-making, while book smarts tend to dig into their models – often to no avail because the market is non-stationary.
Thus, street smarts beat book smarts in trading. Of course, the optimal would be to have a little of both worlds.