The Striker Report

In trading as in life, things we notice tend to get more psychological weight than things we don't.

Cognitive theorists refer to this process as "attentional bias": the tendency of an observer to ignore the unseen or unconsidered and to focus on what is immediately evident - particularly the traumatic.

Case in point: the current issues in American financial regulation. To be sure, for account holders at MF Global and PFG, the recent history has been traumatic. The markets cannot function without a measure of trust, yet here we had two train-wrecks, one quite large, in the space of several months. The temptation is strong to assume culpability on the part of regulators- why didn't they prevent the fraud? And if they can't do their job, why bother trading the markets?

The NFA and the CFTC are scrambling to answer that question. According to the current complaint, PFG falsely told NFA auditors that it held in excess of $220 million of customer funds when in fact it held approximately $5.1 million. In response to this infraction, the CFTC has revised its rules to require clearing firms to adhere to the net liquidating equity method of margin maintenance - no longer will firms be allowed to over-extend. This, of course, would not have prevented PFG from lying about its book.

Such risk is certainly worthy of investor attention. Nevertheless, it is our view that the events of the last few months have encouraged unwarranted cynicism on the part of many brokers and traders. This is not to downplay the seriousness of the breach of fiduciary responsibility, but to point out that in spite of these aberrations, overall, the business of commodity markets works remarkably well, as does its regulation.

As evidence, consider the fact that these markets continue to attract large pools of capital. According to The City UK, commodity assets under management more than doubled between 2008 and 2010 to nearly $380 billion, while inflows into the sector reached a record $72 billion in 2009. To be sure, the MF Global debacle has caused a drop in open interest. But given the prospects of further global volatility, it seems likely that the markets will recover, and money will continue to flow in the direction of commodities, where investors can be long or short in a matter of milliseconds. The exchange of long and short positions in futures on a daily basis is business as usual, as is the regulation governing these transactions.

But business as usual does not make headlines: Aberrations do. The problem with attentional bias is that it can result in cognitive distortion - in particular, overgeneralization: the tendency to assume patterns that may not exist. Paradoxically, attentional bias often results in the very pain it was triggered to avoid. The opportunity costs of over-generalizing in the case of regulatory lapses may be costly, as nervous investors can miss out on opportunities in oil, gold, soybeans, or natural gas. Instead of panicking and running from the futures markets, traders should carefully weigh the investment records of the firms they do business with, with a particular eye toward established, reputable companies.

Our pre-historic ancestors had good reason to operate from fear, to remember pain, and to see patterns, real or imagined. But attentional bias and the fear associated with it can interfere with sound investing. While it is crucial that customers conduct due diligence in examining clearing firms, and keep abreast of regulator activity, it's also important to remember the big picture: Thousands of traders conduct sound business every day in our regulated markets, making modern life possible.