4 Four Truth of Finance

8/12/2019 4 Four Truth of Finance

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The Four Terrible Truthsabout Finance and

The Psychology of MarketInformation & Trending

Markets


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Rule 1: The Market is ahead

The sum of the insight of all current and

potential investors is normally more than

one single human being can grasp.

We have to agree that it is a challenging

task to be ahead of the general markets

knowledge and its early discounting of

such knowledge in its prices.


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Rule 2: The Market is

irrational

The market may react quickly to facts, but it can

also be subjective, emotional and ruled by the

whim of changing trends.

In periods, prices can fluctuate in step withinvestors financial situation and interests,

shifting between mass hysteria and indifference

rather than security values.

Individual investors attempts to be rational can

therefore actually be irrational behavior.


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Rule 3: The environment is

chaotic.

Macro-economic forecasts are normally

too inexact to have any value for an

investor, especially as economic

interrelations are constantly influenced by

small but crucial, details no one could

predict or gauge, but which can change

everything.


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Rule 4: Charts are self-

fulfilling

If many people use the same chart

systems they may profit on their trades,

regardless of whether they actually are

right.


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The Psychological Phenomena

during Trending Markets

1. Prospect Theory We have an irrational tendency to be less willing to

gamble with profits than with losses

2. Magical Thinking

We think that a certain behavior leads to a desiredeffect, even when we know of no explanation andwhen there is in fact none

3. Persuasion Effect We are more persuaded by a credible source than

by a credible argument

4. Self-persuasion When realities are in conflict with our attitudes we

change the attitudes rather than accepting the

realities


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during Trending Markets (Cont)

5. Representativeness We tend to think that trends we observe are likely to continue

6. Adaptive Attitudes We develop the same attitudes as people we associate with

7. Self-realizing We do something because it makes us feel that we are

something

8. Ego-Defensive Attitudes We adapt our attitudes so that they seem to confirm the

decisions we have already made9. Anchoring

Our decisions are influenced by input that seems to suggestthe correct answer.


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10. Assimilation Error We misinterpret information that we receive so that

it seems to confirm what we have done.

11. Selective Exposure

We try to exposure ourselves only to informationthat seems to confirm our behavior and attitudes.

12. Selective Perception We misinterpret information in a way that seem to

confirm our behavior and attitudes.

13. Overconfident Behavior We overestimate the likeliness that we would have

been able to predict the outcome of a past series ofevents.


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14. Knowledge Attitudes We chunk data into manageable clusters, each of which is

processed as a simple attitude. This process can be changedif over a period of time we receive information that contradictsour attitude. A sustained period of sideways volatility and trend

violations can have that effect.

15. Hindsight bias

We overestimate the likelihood that we would have beenable to predict the outcome of a past series of events.This can happen as the trend is violated and weconclude that we actually should have known, or didknow. Hindsight bias makes us more eager to correctour mistakes at the best opportunity.


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16.Regret Theory

We try to avoid actions that confirm that we have mademistakes. This may take place if we have bought close tothe top and then see the prices fall. We will now want to

sell if we can get out at the same price that we bought at.

17.Cognitive Dissonance

Cognitive dissonance occurs when evidence shows thatour assumptions have been wrong. We try to avoid such

information, or distort it, and we try to avoid action thathighlights the dissonance. Cognitive dissonance effectsdelay our change of attitude, which means that mostmajor turning points take some time.


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The Psychology of Trending

Markets

Staircase patterns

Markets follow trend lines and other technical analysisindicators and react strongly if they are violated

Markets are carried by their moving averages

Volumes goes up as markets are in rising trends; it goesdown when they are in falling trends

Increased number of active investors as the market goesup

News is interpreted in a way that supports the trend The trend starts feeding on itself

Bad news is ignored

Chart formations that typically indicate continuation


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Staircase Patterns

Buying when the price retracts to a level

where you previously sold

Most relevant psychological phenomena

Knowledge attitudes

Ego-defensive attitudes


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Markets follow trend lines and other

technical analysis indicators and react

strongly if they are violated

Conscious trading on trend lines and other

technical indicators


Magical thinking

Hindsight bias


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Markets are carried by their

moving average

Gradually changing attitudes

Most relevant psychological phenomena Knowledge attitudes


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Volume goes up as markets are in rising

trends; it goes down when they are in falling

trends

Profit-taking in rising markets, lack of loss-taking infalling markets


Prospect theory

Certainty effect


Regret theory

Mental Accounting

Cognitive dissonance

Overconfidence


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Increased number of active

investors as the market goes

up Investors talk about their investmentsuccesses to friends, who then decide to

join the market


Self-realizing attitudes


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New is interpreted in a way

that supports the trend

Journalist and analysts follow the trend


Adaptive attitudes


Assimilation error

Selective exposure

Selective perception


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The trend starts feeding on

itself

The mere fact that there is a trend makes

people believe that it will continue


Persuasion effect

Representativeness


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Bad new is ignored People do not notice bad news, or they do not

believe it is important because they do not wantto, and because the bull market indicates tothem that the bad news cannot be serious

Most relevant psychological phenomena Persuasion effect

Representativeness


Assimilation error Selective exposure

Selective perception


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Chart formations that typically

indicate continuation

The trend is interrupted for reasons that

are only temporary, buying pressure is

building up and will increase when the

patterns are resolved


Knowledge attitudes



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Six Special Types of Investors

(Garfield, 1992)

1. The Overly Caut iou s o r Parano id Investor

- who does not really trust brokers, systems or themarket

2. The Conf l ic ted Investor- who cannot relax from the trading activities, and

who cannot settle down on clear opinions aboutthe markets

3. The Masked Investor

- who seeks self-fulfillment through investments,and who professionally calculates each risk.


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Six Special Types of Investors

(Garfield, 1992) (Cont)

4. The Revenging/Consumed Investor

- who is absolutely consumed with themarket

5. The Fussy Investor- who gets wrapped up in details

6. The Depressed Investor

- who is never satisfied, irrespective ofwhether he is winning or losing


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Comparison with Mental Disorder

Categories

The Overly Cautious or Paranoid

Investor

Paranoid Personality

Disorder

The Conflicted Investor Borderline Personality

Disorder

The Masked Investor Narcissistic PersonalityDisorder

The Revenging/Consumed

InvestorAvoidant Personality

Disorder

The Fussy Investor Obsessive-CompulsivePersonality Disorder

The Depressed Investor Depressed Personality

Disorder


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Panics

Sudden Acceleration in the marketdeterioration

Significant falls lead to outbreak of panic


Anchoring

Hindsight bias

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