In today’s
post I firstly look at the question of whether man is rational or irrational? I
also want to introduce a brilliant book called ‘I Mammal’.
The concept of man’s rationality is a crucial concept in economics and finance. – Homo economicus is the term given to humans in traditional economics and implies a rational and narrowly self-interested actor who makes judgments aimed to maximize ones utility. I believe that most people who haves worked in trading or on a trading floor believes this to be complete trash: - The rational man theory has in fact taken a real pasting over the past few years, particularly from the behavioural economists who believe that man has a limited capacity for rationality and self-control, and does not always act purely out of self-interest. However does this mean we act irrationally? Often one hears the jibe that traders and markets are totally irrational, and there seems to be no end of evidence wheeled out to emphasis this point, yet irrationality is not the same as ‘limited rationality’. I have a problem with the idea of traders displaying irrational behaviours in the financial markets; this just seems too convenient a label to attach. One of the problems however in defence of this is that actions and decisions are often looked at by others with the benefit of hindsight and are not considered within the context at the time. From another person’s perspective these actions may seem irrational; however we are not talking about another person’s perspective here. - The Nasdaq/Dotcom bubble is often cited by many to emphasize their point about irrational market behaviour, however I will use some scenarios as examples from the 1998/99 Nasdaq/Dotcom to emphasis my point.
Example 1: The Nasdaq and many tech and dotcom stocks had been shooting up in value rapidly during 1998 and 1999. A trader’s job is to make a profit from the markets, they do not really care too much about the valuation of a stock, they care whether they can buy it at one level and sell it for a quick profit at a higher level. – Contrary to common belief, trading is not about buying low and selling high, it is about buying something that you think other people will pay more for (Check out my post on Keynes’s beauty contest). Buying something that has gone up in value because you think that someone else will pay you more for it, irrespective of its perceived value, is perfectly rational in this context.
Example 2: Consider the manager of a large investment fund. Many fund managers participated in the Nasdaq rally, despite the view that many stock valuations were overvalued. However, consider the context of the time; a manager who ignores the wishes of his investors risks losing their client’s money from their fund and their own job, surely in light of that it was perfectly rational to participate in the rally. - Imagine if you will that you were running an investment fund not invested in tech stocks in 1999, your clients were seeing other funds making spectacular gains, if you wish to hold on to your clients money you have to alter your allocation and buy tech stocks of risk your client’s ‘voting with their feet’. – This was the dilemma faced by the late Tony Dye, legendary UK fund manager of the 1980s and 1990s. Dye had run one of the UK’s largest pension funds and stood full square against the idea of participating in the tech stock boom (as did Warren Buffett notably). Dye stuck to his guns, but during 1999 the firm he worked for was ranked 66th out of 67 for performance amongst Britain's institutional fund managers, and was hemorrhaging clients. In February 2000, just as the Nasdaq was topping Dye was sacked.
Example 3: How about from the perspective of a Hedge fund manager running a long/short strategy. Consider a strategy long of traditional stocks and short of Nasdaq stocks in 1999 and bear in mind that this strategy was probably leveraged up many times. On the one hand the strategy would be losing money on a re-valuation basis, however a far greater threat would be the loss of liquidity as the margin calls start coming in. – The Hedge Fund manager, may believe that ultimately the strategy is right (and they would have been proved right in the long run) however the rational thing was to ensure the fund’s survival, which was threatened by margin calls. Thus the rational thing to do would be to unwind the position, which would mean buying back the Nasdaq stocks they were short of.
These three examples are used to emphasize the point, that actually most behaviours which are often judged after the event and out of context, and thus labelled as irrational are perfectly rational when viewed within the right context. Typically it is observers, who have the luxury of not having 'skin’ in the market who talk about traders acting irrationally or people on the wrong side of the market who wish to justify their position.
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Finally I want to use this post to introduce a brilliant book I have just finished reading, which though nothing to do with trading, yet I feel is so applicable to understanding much of what happens in trading with regard to people’s behaviour. - However before I discuss that I want to talk about what Keynes (that two mentions for him now) labelled ‘Animal Spirits’. - Keynes used this term in his 1936 book The General Theory of Employment, Interest and Money to describe emotions which influence human behaviour. The reason I mention this is because the book I am referring to is called ‘I Mammal’, it introduces some fascinating theories proposed by Loretta Graziano Breuning PhD.
The premise behind the book is that much of our behaviour can be explained in terms of the link between our brain, our status and happiness. More specifically the book looks at our Mammal Brain, an inheritance from our mammalian ancestors, and how this is the default ‘operating-system’ driving most of our behaviours and decisions. Our mammal brain does not verbalise like our more recently evolved pre-frontal cortex, instead it emits neurochemicals to react to the world and reacts only to events in the present time, though often in relation to past experiences. - This leads it directly into conflict with our incredibly powerful pre-frontal cortex, which has the ability to anticipate future consequences, and thus can perceive, plan and prepare for the future. Guess which one comes out on top. – I’ll give you a clue, one of them is relatively new and makes us fantastically adaptable and conscious of the world around us, the other has enabled our ancestors to survive for millions of years, by reacting to threats and ensuring the survival of its DNA. – Our brain by default is driven by our ancient mammal operating system; it operates and responds to threats so fast that it can make us hit the brake pedal on the car even before we are consciously aware of the need to do so. Essentially our mammalian brain, our default operating system, works on autopilot, it lies behind our emotions and there is not a single decision we make, which does not involve input from our emotions. – This theory is both a complex and beautifully simple: The mammal brain has evolved over millions of years, rewarding behaviours which help promote the survival of the mammal it inherits and its offspring by releasing neurochemicals. Some of these neurochemicals make us feel good when we carries out virtuous actions which would aid our survival in natural environments, and other neurochemicals would make us feel bad to warn us to avoid threats and situations which are detrimental to our survival. We are thus drawn towards behaviours similar to our mammalian ancestors, such as joining social groups (Herding) and seeking high status within those groups, to be in a position of opportunity and safety. Time and space to expand on this are limited, but next time you look back over your trades, and question yourself as to why you did not stick to you plan, perhaps you can start to look at your emotions or ‘animal spirits’, and start to understand what went wrong. – It pays to heed your emotions in trading.
Advertisement - 'Trader Learning & Development' offers courses, programmes and masterclasses to help traders with their 'Continuing Professional Development (CPD). Please visit our website www.traderld-edu.org to find out more about how we can help you and your business. ________________________________________________________________________________________________________
Finally I want to use this post to introduce a brilliant book I have just finished reading, which though nothing to do with trading, yet I feel is so applicable to understanding much of what happens in trading with regard to people’s behaviour. - However before I discuss that I want to talk about what Keynes (that two mentions for him now) labelled ‘Animal Spirits’. - Keynes used this term in his 1936 book The General Theory of Employment, Interest and Money to describe emotions which influence human behaviour. The reason I mention this is because the book I am referring to is called ‘I Mammal’, it introduces some fascinating theories proposed by Loretta Graziano Breuning PhD.
The premise behind the book is that much of our behaviour can be explained in terms of the link between our brain, our status and happiness. More specifically the book looks at our Mammal Brain, an inheritance from our mammalian ancestors, and how this is the default ‘operating-system’ driving most of our behaviours and decisions. Our mammal brain does not verbalise like our more recently evolved pre-frontal cortex, instead it emits neurochemicals to react to the world and reacts only to events in the present time, though often in relation to past experiences. - This leads it directly into conflict with our incredibly powerful pre-frontal cortex, which has the ability to anticipate future consequences, and thus can perceive, plan and prepare for the future. Guess which one comes out on top. – I’ll give you a clue, one of them is relatively new and makes us fantastically adaptable and conscious of the world around us, the other has enabled our ancestors to survive for millions of years, by reacting to threats and ensuring the survival of its DNA. – Our brain by default is driven by our ancient mammal operating system; it operates and responds to threats so fast that it can make us hit the brake pedal on the car even before we are consciously aware of the need to do so. Essentially our mammalian brain, our default operating system, works on autopilot, it lies behind our emotions and there is not a single decision we make, which does not involve input from our emotions. – This theory is both a complex and beautifully simple: The mammal brain has evolved over millions of years, rewarding behaviours which help promote the survival of the mammal it inherits and its offspring by releasing neurochemicals. Some of these neurochemicals make us feel good when we carries out virtuous actions which would aid our survival in natural environments, and other neurochemicals would make us feel bad to warn us to avoid threats and situations which are detrimental to our survival. We are thus drawn towards behaviours similar to our mammalian ancestors, such as joining social groups (Herding) and seeking high status within those groups, to be in a position of opportunity and safety. Time and space to expand on this are limited, but next time you look back over your trades, and question yourself as to why you did not stick to you plan, perhaps you can start to look at your emotions or ‘animal spirits’, and start to understand what went wrong. – It pays to heed your emotions in trading.
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