Sign in     Like us on Facebook Follow us on Twitter Watch us on YouTube

News and Blog

Join 5000 other sharemarket traders for regular blog updates!

Browse to a category

Blog Search

Why?

Apropos of this article yesterday I found this  little piece

Episodes of extreme market volatility demonstrate the role of emotion-based trading in moving stock and commodity prices.  The internet stock bubble is an obvious example of emotions overtaking investors’ “common sense.”  More recently, the extreme moves of currency (e.g. USD) and commodity (e.g. gold and oil) prices prior to the invasion of Iraq in March 2003 illustrate the influence of anxiety in driving prices. The power of the field of behavioral finance lies in its ability topredict and explain such emotion-driven price movements. Behavioral finance encompasses the study of both repeating market patterns and “irrational” investor behavior.
The discoveries of behavioral finance are descriptive.

Understanding simply that a price pattern exists in the markets is much different than understanding why that pattern exists. In order to gain a deeper understanding of what moves investors and markets, recent research has turned its focus toward studying brain processes themselves.
Studies of the brain (neuroscience) are teaching us how, why, and when investors make decisions to buy and sell.  If we know what information and emotional states will stimulate buying or selling, then more accurate (and profitable) forecasting models of the markets can be developed.  There are many applications of contemporary neuroscience research directly to investors participating in the financial markets.
Our primary goal is to understand the neural basis of investors’ buying and selling decisions.  On a large scale, this understanding will help us to create better market models (to ultimately reduce both price inefficiency and the risk of market crashes). Individually, we can help investors decide what type of money-management strategy fits their unique personalities.

(my emphasis added)

Despite being more technical in tone than yesterdays missive about who or what might be driving the market this piece falls into the same trap of believing that the answer to profitability lies in understanding why something happens in a market. Notice that in the article the emphasis moves from the individual which is the focus of  trader psychology to the focus on the group. This shift in focus brings with it the belief that group behaviour can be predicted and might therefore one day be a profitable tool.

However, to my way of thinking there is a problem here and it is a contradiction within the article – if investor behaviour is irrational then it is somewhat chaotic in nature. That is a change in initial conditions will produce vastly different outcomes.

From my perspective whether markets are irrational or not or by extension that this irrationality might one day produce a prediction engine is largely an irrelevancy. I consider it irrelevant because knowing is not really an issue – we know that market behaviour is interesting and fascinating to watch. However, this is an academic exercise and not a profit driven one, the profit is derived simply by watching price action unfold and in understanding your own behaviour. The question as to why something might happen or not happen is largely an irrelevancy to a trader.

 

email

Comments

  1. The other problem with this type of thing is that it assumes that the input from the model doesn’t change the market. If, for example, the model says buy on Monday mornings because the rest of the week is higher then it’s only a matter of time before the next model will start saying buy on Friday Afternoons and so it go’s

    Ultimately the market is the difference between value and a human perception of value. Until humans change the market won’t so as you say, we might as well just get on with looking for what is happening and making the most of it

    • Thats true – there is a tendency within any sort of financial modelling be in strict econometric modelling or the modelling of human behaviour to assume that the world is static and fluid. Even modellers who are a little bit more sophisticated speaks in terms of chaos and its impact upon models but they fail to grasp the underlying point that small changes in the initial condition of an event leads to vastly different outcomes. To me chaotic is roughly equivalent to fluid – neither one conforms very well to set patterns.

      Hence the ultimate need for the trader to be reactive rather than predictive in approach.

Speak Your Mind

*

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.

email