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.