By Meir Barak

Breaking away from conventional text book economic premises and learning about the psychological aspects of market behavior, brings fascinating insights into the irrational aspects of trading, and the way the markets operate.

+ The Fundamental Approach

While studying economics at university, I was taught two important premises: The first premise maintains that the financial markets are efficient. The second premise maintains that market participants operate solely in a rational manner. According to economists, participants have all the relevant information, and it is used by them in order to attain their personal goals in the most effective manner. Is this true?

As an obedient student I had to accept the academic consensus, read and understand the logic in company profit and loss reports, and invest my money in accordance with the fundamental premises. For decades the economists’ view remained common knowledge. However, unofficially, we all knew that something was wrong. We discovered that the market has a life of its own, and in many cases the market operates contradicts fundamental principles. If life was so simple, we could read the economists’ suggestions, regularly purchase in the stock exchange shares that are undervalued, and always make a profit.

+ The Psychological Approach

Not any longer! Today we officially recognize the fact that alongside the fundamental economic approach is the psychological approach. We have made a transition to an era that is firmly under the control of the psychologists. Today, in contradiction to the fundamental approaches of “universal logic” and “market efficiency” we now know that the market is controlled by people who are flesh and blood. People with feelings, desires, and fears. People whose behavior can be predicted. Being able to predict how they handle themselves psychologically can lead to an ability to predict how the markets will behave, and this in turn will lead to financial success.

In an efficient market, where knowledge is common property, phenomena such as trends and basic trading rules cannot exist. An efficient market operates in a coincidental manner. In an efficient market, past, present, or future prices have no significance. In an efficient market there is no technical analysis, only fundamental analysis. Many studies clearly indicate that technical analysis does work. In a recent study, the efficiency of a technical chart formation called Head and Shoulders was tested. The results showed that the turnover on the day this chart formation began to develop was 60% greater in comparison to the previous cycle. Many traders buy and sell shares solely on the basis of a graphical representation. Since a growing number of traders rely on graphs, then even if we are firm believers in the efficiency and logic of the markets, we will not be able to be mere passive observers, bury our heads in the sand, and ignore the mass psychological flock mentality.

+ Behavioral Models

Since we are dealing with flesh and blood, we should inform ourselves about the basic behavioral models according to which people act. I will mention a number of models: An estimation of chances: often we tend to ignore our own knowledge and judge events according to an estimation of our chances of success and failure alone; conservative – we change our minds too slowly in connection to new events and new information; self-serving bias – we tend to attribute our success to our own actions and our failures to external events or other people; overconfidence – we tend to overestimate out abilities. Learning about our disadvantages will help us understand why often lack of common sense is in fact absolute common sense, or in other words: when the sun shines over Wall Street – pull out your umbrella.

One of the greatest economists, John Maynard Keynes, wrote in his 1936 book “The General Theory of Employment, Interest and Money”: “There is nothing so dangerous as the pursuit of a rational investment policy in an irrational world.” Translating Keynes’ quotation into my simple language as a share trader: If others invest “rationally” without success, with the purpose of matching share prices that they perceive as irrational, with the fundamental figures they perceive as rational (arbitrage), then the more they fail the greater my chances for making money.

+ Example

To understand my argument, I will present an example of a company that announces better than expected results. The fundamental prediction is that the share price will rise, but, as often occurs, the share price falls. The reason for the falling price could be simple: a large investment fund decided that it has profited enough on the share and decides that it is time to sell. The fundamental investor will treat the falling price as irrational and will buy cheaply, whereas a day trading professional will see the falling price as very rational (the will of the market) , and will try and profit by short selling as the share depreciates in value. He who does not know that the fall in the share price was the direct result of share selling by the large investment fund, perceives the process to be very irrational. But is it right to say that the market behaved irrationally? The conclusion: If you have a degree in economics, you have a greater chance of losing money.

How does a fundamental investor handle losses? By doubling the investment in the hope of being right, and emerging victorious at the end of this logical process. The stock exchange is just like the casino. A gambler that loses doubles the stakes in the false hope of beating the house. With each subsequent loss the stakes are doubled. At a certain stage the gambler will reach either a personal financial limit or the table’s limits, and the casino (and in our cases, the market) will win. A fundamental investor will maintain that it is worth while taking a chance because in the long run prices will match themselves with rational values. Of this John Maynard Keynes said, in another favorite quote of mine: “In the long run we are all dead.”

In order to illustrate the irrationality of elements of which the market consists, I will present the details of a study in which the willingness of people to take a chance was examined. During the study, subjects were asked to choose between the following options:

  • Option A: Gambling on an 80% chance of making $4,000, and a 20% chance of making nothing.
  • Option B: A guaranteed profit of $3000.

What would have you chosen? The results of the study demonstrated that despite the financial logic of choosing option A., 4 out of 5 of the subjects chose the poorer option B. In contract, look at results when subjects faced the following options:

  • Option A: Gambling on an 80% chance of losing $4000, and 20% on losing nothing.
  • Option B: A definite loss of $3,000.

In this instance, over 9 out of 10 subjects chose option A and to gamble, instead of opting for a definite loss, even though mathematically option B is best. Over the years, a parallel mode of investor behavior has become all too familiar to me. One of the major mistakes made by rookie traders is the cognitive inability to exit at the predefined stops (preferring to gamble on the share recovering so as not to have to suffer the loss), and their tendency to even double their gamble when faced with a larger than usual loss (known in professional language as “average down”). On the other hand, when the same investors profit on a share, they tend to realize their profit too soon and settle for a lower profit instead of waiting for a larger profit.

In conclusion, the question each and every one of us must ask as a trader or investor is: “Am I able to match my behavior and way of thinking to that of the market? The majority will respond in the affirmative, and the majority will be wrong!