Type I and Type II errors and investment decisions

Type I and Type II errors from any model is a fact of life but we need to place this in a broader context related to investor behavior. An investors who makes more Type I errors with their decisions is gullible while the investor who makes Type II decision errors is a skeptic. What type of investor are you? It should not be hard to look back over the trades accepted and rejected to see if you are gullible or a skeptic.

Let's go back to our statistics 101 class. A type I error is when we accept a hypothesis that is false, a classic false. What we perceive is in reality untrue. A Type II error occurs when we reject a hypothesis that turns out to be true, a classic false negative. What we perceive to be false is actually true.

 Of course, we are simplifying, but you can think about any investors who may make some mistakes in there thinking as falling into either one of these error camps. If you accept wisdom that proves to be false you are gullible. You act on everything you hear only to find out that it is false. You are just more accepting of thinking that proves to be false. On the other hand, if you are constantly rejecting different market conjectures that may prove to be true, you are a being a skeptic. Everyone is wrong and the markets are always efficient so there are no opportunities.

Being a skeptics has its advantages but when cash rates are low the cost if sitting is high. Being gullible increases transaction costs and portfolio volatility. Of course, if this was the statistical world we would increase the power of the test through increase the sample size to lower sample error. You cannot do this with unique decisions. Would you rather take action and then prove to be wrong or would you rather reject advice only to find out it proved to be true?