Behavioral Finance

Every time I read a new trading book these days, they all seem to be writing about the new hip topic of “behavioral finance”. I have been doing some research into this area to see if it can give my trading an extra edge. This post explains what I have learned so far.

Every time I read a new trading book these days, they all seem to be writing about the new hip topic of “behavioral finance”. I have been doing some research into this area to see if it can give my trading an extra edge. This post explains what I have learned so far.

What is Behavioral Finance?
For many years economic and financial theory has been based on the rational actor theory, which asserts that individuals act rationally and consider all available information in the decision making process.

Long before academics got involved in finance, speculators have always known that this concept is pure bunk. Exceptionally profitable speculators have always made money by exploiting consistently irrational behaviours of other speculators. For example, there are traders out there that are happy to exploit the patterns resulting from the hope, fear, greed and despair felt by other traders.

Behavioral finance is a field of academic research that uses modern jargon to explain what traders have always known. Behavioral finance uses theories about social and psychological biases to tries to understand how people make financial decisions and then in turn use that to explain the movement of prices, returns and the allocation of resources.

The Parable of the Dollar Auction Game
The best example I have seen that demonstrates that people are far from rational is the “dollar auction game”. This parable comes from Rob Booker’s book “Adventures of a Currency Trader: A Fable about Trading, Courage and Doing the Right Thing“. (The book itself is truly awful and I am sad to say this parable is the only good bit in it)

In this story, Harry Crumb, a naive retail forex trader and the central character of the book, is taken to a coffee shop by his mentor, an olive munching Wall Street veteran. Harry’s mentor decides to demonstrate how irrational markets are by playing the dollar auction game with some of the other cafe patrons.

The game involved Harry’s mentor playing the role of auctioneer who volunteers to auction off a hundred dollar bill to the other punters in the coffee shop. The auction begins with one of the punters bidding 1 dollar, hoping to make a 99 dollar profit. He was quickly outbid by another punter bidding 2 dollars, as a 98 dollar profit is still desirable. Another punter then bids 3 dollars, hoping to make a 97 dollar profit. The bidding goes on methodically until one of the punters bid 98 dollars. It is at the point in the auction there is a long pregnant pause before the auction takes a strange turn with one of the bidders jumping to $101 and the other punters irrationally start bidding more than $100 to win a $100. At this stage things really get out of hand and the bidding goes as high as $200 dollars before one of the punters gets really angry and the auction ends in tears.

The parable demonstrates how an irrational escalation of commitment ends up forcing the players to bid more for something than it is worth. The parable also neatly demonstrates the breakout of the price above $100 when one of the punters decides that it is worth paying more than $100 to win. Lastly, the parable shows how prices can move parabolically before they collapse.

Rob Booker is not the inventor of this parable. The dollar auction game has been talked about in behavioural finance circles for years. If you are wondering why the hell anyone one would pay more than $100 for a $100, that is because Rob missed an extra wrinkle in the auction that is present in the academic version of the story. In the academic version of the story the second-highest bidder must also pay the highest amount that he bid, but gets nothing in return. This rule creates a race condition for the second bidder who must by definition drive the price above parity in order not to be the second bidder.

Core to the study of behavioral finance is the identification of biases. For example:

Irrational Escalation of Commitment bias refers to a situation in which people can make irrational decisions based upon rational decisions in the past or to justify actions already taken. Examples are frequently seen when parties engage in a bidding war; the bidders can end up paying much more than the object is worth to justify the initial expenses associated with bidding (such as research), as well as as part of a competitive instinct;
Representativeness is a bias that leads us to estimate the likelihood of something happening on the basis of how closely it resembles something else, whether it is information or noise;
Anchoring is the tendency to rely too heavily or anchor on readily available information
Confirmation bias, where once traders have an idea for a trade they tend to only see the confirming information to prove their idea;
The Law of Small Numbers, where traders jump to general conclusions quickly based on a small number of facts;
Loss aversion is the tendency for people to have a strong preference for avoiding losses over acquiring gains; and
Lotto effect, is the tendency for traders to think they have more control over their situation then they really do, much in the same way people think that by choosing lotto numbers they will improve their chances at winning.
These are just a few. There are numerous other biases listed in the behavioral finance literature.

How can I make money using Behavioral Finance?
The first time I read about behavioral finance I wondered how I could improve my trading edge with it. At first glance behavioral finance seems to be nothing more than a big list of biases and none directly say “if you do X then you will make money from people who do Y”. When I sat back and thought about it I realized that behavioral finance is a thinking tool to help you reason about the market and not a predictive tool. It is just like technical analysis is not a predictive tool, it is a tool to help you structure price action and help you think about different market scenarios.

Probably the most common use of Behavioral Finance is as an explanatory theory for why certain technical analysis tools and techniques are likely to work. For example, anchoring is a great explanation as to why support and resistance levels work and loss aversion explains why trends collapse extremely quickly. In this case behavioral finance also helps us explain why certain aspects of technical analysis are likely to work and why other aspects, like bizarre fib extension ratios based on astrology, are totally meaningless.

The other area you can use it is to identify weaknesses in your own approach to trading. Behavioral finance gives us a way to name our demons. If you can name your demon, you have a chance to banish it. For example:

Lotto bias often means we cling to useless forms of analysis that provide us with no edge over the markets;
Loss aversion often means we scratch trades that need time to mature;
Representativeness bias drives us to keep on blindly applying a trading system in the wrong kind of market; and
Anchoring commonly happens when traders get married to their positions. There is a saying that bad traders divorce their spouses sooner than abandon their positions. Loyalty to positions is not a good thing for traders.
Finally, you can capitalize on certain behaviors. For example, the law of small numbers and confirmation bias often asserts new short lived trends in the market based on nothing more than a string of a few positive economic results in a row and some random price movements in a confirming direction. If you couple this with loss aversion, you have a contrary trade opportunity.

Parting Thoughts
“I can calculate the motions of heavenly bodies, but not the madness of people” Sir Isaac Newton (1720) after he lost money investing in the south sea bubble.

Behavioral finance is hardly a holy grail. Individual behavior is difficult to predict and behavioral finance is not going to help you deal with illiquid markets. Trending liquid markets on the other hand attract crowds. Crowds are much more primitive and their behavior is more repetitive and predictable. This is where behavioral finance gives us an edge. Our job is not to argue with the crowd, telling what’s rational and what’s irrational. We need to identify crowd behavior and decide how best to trade it.