The original version of this article appeared in Traders Day Trading on October 10, 2011
Behavioural finance is primarily based on observing human beings make financial decisions. These decisions are often based on what’s called a heuristic, or “rule of thumb”, and may therefore be biased or even illogical.
Unlike modern finance, behavioural finance does not start with a theoretical construct of man, as in the hypothetical, perfectly logical and all-knowing Rational Economic Man, on which most of classical economics is based.
Instead, behaviour finance is based on observing real human beings make decisions, whether these are the right decisions or not. Behavioural finance practitioners observe, record, analyse and then try and come up with models to explain what they see in the real world.
This real world dimension is what powers and gives behavioural finance such an edge over more traditional investment methods based on economic theory.
In my book, published by Harriman House, I first classify behavioural finance into six categories. I take all the important heuristics and biases discovered so far and classify them according to whether they deal with how human beings cope with complexity, perception, and aversions. There are also behavioural factors resulting from our own self, from society and from gender differences.
Men, for example, are usually more risk-taking and overconfident than women and this may have to do with the level of testosterone in the blood. Experiments have even been conducted to relate the propensity to take risk to the relative size of one’s fingers!
The main society issues are those resulting from the market because the market is, in this context, the main phenomenon we have to deal with. Today, markets and the communications which feed them have been boosted by the internet, mobile and other electronic communication systems. Make no mistake though: this huge, pulsing electronic crowd is as real as a crowd watching soccer or protesting in the street.
In the second part of the book, I apply these behavioural factors to trends, support & resistance levels, and extreme price formations such as we witness when bubbles are formed and collapse.
I have identified twelve behavioural factors powering trends. The most obvious is simplification. Simplification is one way we try to cope with complexity. Our brain is often too limited to deal with all the dynamic change and data in our environment and we therefore simplify in order to be able to cope. A trend, once formed, is a relatively simple thing to understand and this comes as a relief. What can beat following something you understand?
The promise of gain in following something as simple as a trend leads to herding, another behavioural factor, this time stemming from our impulse to belong. Participants who were on the sidelines but who become aware of the trend go join it and this herding makes the trend stronger.
Herding provides protection, not just gain! If you are running institutional money, what’s worse than returning empty handed to your boss after a big run in a security (think gold!) just because you thought you were smarter than the market and refused to join the trend? So if there’s a chance you’ll fail, it’s best to fail conventionally.
Ever wonder why “history repeats itself”? An important factor is what’s know in behavioural finance as recency. We tend to give much more importance to things which happened recently than those in the distant past. There’s no use arguing that gold did nothing but trade in a range for years on end if it’s been going up steadily in recent years. We each tend to adopt a timeframe to understand what’s happening around us and what’s happening today beats history anytime – and that’s one reason we repeat our own mistakes!
The last bias I would like to discuss here is availability. When a trend takes hold, it’s in the news. If the Footsie is up every day, it gets reported. The more it rises, the greater the attention it gets. The good news is everywhere and you cannot ignore it. This “propaganda” effect will eventually tempt us to join the trend and the herd. Again, the trend grows stronger. In the book I examine these and other factors which feed the trend and provide practical examples.
The existence and power of trend has also been examined statistically by researchers using a fundamental or quantitative approach. It has been shown that stock prices exhibit serial auto-correlation, that is, the quoted price of a security today is related and correlated with what it was in previous days. Researchers found that stock prices tend to trend for periods between nine months and a little over one year, and then revert. They also found that buying stocks making new highs is usually a good proposition, if done on a sufficiently large scale.
I have applied my research on trends and volatility to a free and public website called www.ETF-Online-Investing.com. In this website I post monthly signals on which of six international Exchange Traded Funds (ETFs) one should be invested in. Investors are using these signals as asset allocation indicators. We went out of equities in August. At the time of writing, early in October 2011, I have just closed the exposure to commodities and we are currently only in bonds. Not surprising, given how equities are falling around the world.
Anyone can become a member of ETF-Online-Investing.com and you will then get Updates in your email.
Later on in October I am very pleased to be speaking at the annual conference of the Canadian Society of Technical Analysts which will be meeting in Toronto.
My topic will be “The Behavioural Finance of Trends and Volatility”. The presentation will eventually be posted on my Behavioural Technical Analysis website, so watch out for it.
Paul V. Azzopardi BA(Hons)Accy MBA FIA, is an investment adviser who has developed methods using a combination of fundamental and technical factors. He is the author of two books and has been advising and running money for the last twenty-two years.