How To Profit With The Psychology of Markets

We need to start with a definition of Psychology.  We will list several definitions taken off the World Wide Web.

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1)     The science of the mind or of mental states and processes.

2)     The science of human and animal behavior.

3)     The sum or characteristics of the mental states and processes of a person or class of persons, or of the mental states and processes involved in a field of activity: the psychology of a trader; the psychology of markets.

Of these definitions, the third is the one we are most concerned with.  Unlike an academic, theorizing about the markets, we have undertaken to apply what we have learned to predict market behavior.

Classic Economics argues that market participants will act in a rationale manner in terms of buying and selling activity, price discovery, etc.  This behavior is expected to arrive at the most efficient pricing because it is assumed all information is known and that all participants will act rationally.  The Efficient Market Theory or Hypothesis (EMT or EMH) holds that you can not outperform the market without taking on additional risk because you can’t predict the markets direction.

The belief that markets “behave” in a manner that doesn’t fit the assumptions of classic economics is known as Behavioral Economics or Behavioral Finance.    Behavioral Finance believes that market participants may behave in an irrational manner in that participants don’t base decisions on all available information but rather use rules of thumb.  They also arrive at different conclusions based on how a question may be posed.  The result is that markets aren’t “perfect” just as people aren’t perfect.  A primary argument is that if markets behaved rationally, they wouldn’t have the boom and bust cycles where a bubble is formed, eventually bursts, and then another begins to form.  Market participants would take in all the available information and would exit markets that are fully valued, etc.

I am a believer in Behavioral Economics.  I hold a degree in Business Economics which essentially means I was trained to believe in classic economics.  Since Behavioral Economics combines Psychology and Classic Economics, I don’t see the conflict.  While there are three decades of research into this field, the legitimacy of the discipline is only now emerging at Universities.  I believe it will be a compelling field that most finance majors will be exposed to going forward.  Traders, in particular, need to understand what motivates the decisions of market participants.

I believe, in the short term, it is possible to predict market behavior and to profitably trade based on that market behavior than based on fundamentals.  To support that belief, I would cite research in quantitative behavioral finance.  Essentially, that realm combines statistics and differential equations to make short term predictions about market behavior.

The real world problem, versus the theoretical models used, is that the real world has all sorts of exogenous unpredictable events occurring.  Those events create “noise” meaning randomness in market movement beyond what can be predicted.  If the noise can’t be filtered and it is relatively the same level as the impetus behind the psychology of market participants, then real world implementation won’t be successful.

It can take market participants awhile to make a “rational” decision after you have discovered hidden value in a mis-priced security.  Warren Buffet, one of his generation’s greatest value investors, is a poor market timer.  He is willing to take a position based on his analysis and hold it until his assumptions are proven to be incorrect or the security becomes fully valued.  When he famously avoided the tech market in 2008-2009, market participants scoffed at him as the performance of his holdings fell behind in the dot com era.  That bubble then burst and his holdings held up fine when the market collapsed around those “irrational” tech investors.

The point is, he isn’t a market behaviorist and doesn’t try to time the market.  Rather, he does an analysis and if a company is significantly under priced to the value he believe it holds, he takes a position and waits for the market to catch up.  Sometimes, he must wait years to be proven correct.  How would you like to be able to time your long position entry into companies he has faith in to coincide with local price bottoms?  Better yet, how would you like to ride those same stocks higher and then get out of them when they are about to reverse course?

Market behaviorists believe that the psychology driving the markets is the primary factor in market behavior.  As we said earlier, there are always exogenous events that occur that will push the market in one direction or the other.  Those events may have a profound effect on market participants, altering market biases and even helping to reverse prevailing trends.  However, it isn’t the exogenous events themselves, but rather the market sentiment and prevailing psychology which shapes market direction.  If you are able to filter out the “noise” of the exogenous events, you can create a system that can reliably predict market behavior and that will generate trading profits.  In fact, this is what all the large Wall Street banks do with their program trading.  They pay mathematicians and statisticians huge salaries to model the markets.  The trading profits that these banks are currently racking up are in large part to this sort of trading.