MarketPsych - Social media, Behavioural Finance, Psychology and Neuroscience.

I came across a very interesting piece on a blog called ‘MarketPsych: Applying Behavior Finance’. I was particularly interested in their posting on the 3rd January this year. – The link is here. The title of the piece is ‘Using Reason+Emotion to Forecast 2012’.  The article grabbed my attention making some thought-provoking points and assertions and is well worth a read.

A couple of things jumped out at me, particularly in light of the fact that this article was posted on the 3rd January and how market events have unfolded since that time.

Firstly, their assertion that, ‘uncertainty is predictive - in a counter-intuitive way’. Looking at the way markets have started this year, this would go along way to answering all those people, and there are many, sitting around scratching their heads at the performance of the markets so far this year.

Secondly, and I find this really interesting, they have analysed and aggregated the past 13 years of social media chatter by year for 8,000 publicly traded U.S. companies. They found that December, perhaps not surprisingly, has been the happiest and most optimistic time of the year for investors. Perhaps this is one theory why markets tend to experience the ‘January effect’: The January effect has been known for many years and was first described some 70 years ago. Since 1991, not including this year, January has on average returned 6.7% on the SP500.

Following on from this analysis, they have conducted, in their own words -‘basic analysis’ - from which they have created forecasts for stock out- and under- performance using both emotion and reason as the inputs. As a result they identified five companies that they think may outperform and five who may underperform the market for 2012.

Given that this was published on their blog on the first Monday of January, I thought it would be interesting to see how these have fared so far this year. The following table shows % performance ‘Year to Date (YTD)’ as at the close of business on Friday (3 Feb 2012) for the suggested outperformers and underperformers. At the bottom of each group I have calculated the average performance for each group; I have also included the median performance, which I think gives a better reflection, due to the distorting effect of one outlier in a small group. It certainly looks very impressive thus far: 

Finally they talk about some interesting insights from neuroscience, which can have far reaching consequences for our own performance when trading and investing. Whilst it should be no surprise that people get excited when they do (and possibly believe they will) make money, it is however what is happening inside our brains that is fascinating. When we make money this triggers activation in the brain's reward system; however at the same time that excitement leads to a de-activation in the "loss avoidance" areas of the brain.  Let me just re-phrase that slightly: ‘When we become excited about making, or the prospect of making money, we become less able to detect risk, thus perhaps when we need it most, we let our guard down’. – Who as a trader or investor can not resonate with that? 

 

They also talk about how we become ‘emotionally primed’ when watching financial news, (and I would suggest when watching market price action, data releases, and other aspects of trading and investing). They assert that it is common for - our unconscious emotional state to shift from news story to news story - across a spectrum from joy to anger to fear - depending on the message of each story.  As these shifts occur, the brain shifts its decision-making from primarily neo-cortex (analytical) to primarily limbic (emotional).  And most importantly, this shift to emotional decision making is unconscious.

After such a shift, our rational brain (neo-cortex) believes that it is responding to financial circumstances and information as before, but in actuality it has been "emotionally primed" and is reacting to events from within an emotional frame.  

We see this in our own behaviours, when we hear frightening news; we react with more caution, whereas after favourable news, we are inclined to take on more risk. This ties in an aspect of my own ‘Trader Performance’ coaching, where  I suggest to clients that their major market analysis and indeed their thinking should where possible be done, in what I consider a ‘cold-state’, preferably not in front of screens, or away from market activity, or during quiet times. This way decisions and analysis are far more likely to be based in reason, whereas decisions taken in the heat of trading, ‘hot-state’ are far more likely to be poor decisions, based on emotional responses. (Please note; I like emotion as an input into decision making, so I do not suggest ignoring it, but the decisions themselves should be made in a rationale state of mind - where possible).