'Technical Analysis = Behavioral Finance' - An interesting perspective!

The link below leads to an interesting article by Cam Hui of Qwest Investment Management - It asks 'What is technical analysis?', explores ‘Whether it works?’, and addresses some of those criticisms which leads to detractors labeling it as in similar categories such as astrology and voodoo?

In the article Cam refers to research by some leading figures in the field of Behavioural Finance, including the brilliant Andrew Lo, to support his claims that Technical Analysis works. Cam goes on to rather boldly claim that 'Technical analysis amounts to Behavioural Finance' – Whilst I personally would not go as far as that, I can see where Cam is coming from: A view I have long held is that ‘behavioural factors’, which have formed some of the theories behind Behavioural Finance, help in formulating explanations which validate Technical Analysis. – In fact, at a talk I gave to the London branch of the ‘Society of Technical Analysts’ earlier this year, I suggested that had ‘technical analysis’ never existed, then Behavioural Finance would probably have created it.

The link to the article is as follows: http://qwestfunds.com/publications/newsletters_pdf/newsletter_may_2013.pdf

"Stock Chart"Image courtesy of nongpimmy / FreeDigitalPhotos.net".

AUDUSD – CORRECTION OR CONSOLIDATION?

As long-time readers know, I only occasionally comment on markets, with most of my other commentary saving itself more generally for aspects of trader performance, psychology and behaviour. One of my favourite markets to comment on (and trade) is AUDUSD fx. Maybe its because I have a good record on this in recent year, though whether that is skill or luck who knows?

My first attempt at calling the AUDUSD this year was Back in February. Whilst my call proved correct, my timing was a little premature. Nonetheless, I did qualify this in the title of the post ‘Is the AUDUSD in the early stages of turning?’ Approximately 2 months later it finally turned.

My next attempt was to call a bottom for the strong down-move from April through to late June. The post on the 25th June was titled ‘AUDUSD FX SPOT - Possible pause in the downside as market hits key Fibo levels.’. Whilst the call has proved prescient, the market did move slightly lower than I suggested it might, though in truth this was short-lived and quite marginal.

Over the 2 calls, I’d give myself a mark of around ‘8 out of 10’. – I did I’m glad to say have the trade on too, though I took my profit a little early, but still managed to catch a nice move.

Where to next then? My favoured call is that we are in the early stages of a correction, though this is not a high confidence call at this stage, and it is quite possible that the market is consolidating ahead of further decline. Looking at the attached 8 hour chart below, what appears to be a rounded basing pattern may have formed, though until it clears 9280 and then 9326 on decent volume and manages to hold those levels there is a risk of failure in the basing call. Looking at where the correction may move to if it does unfold. I’m guessing gains could move to around 9580 to 9600. This is where the 2012 low and the level where 38% correction of the drop from April occurs. A sustained move through 96.00 could possibly push higher closer to 98.00. – Personally I still remain bearish longer-term, hence any rally is most likely a contra-trend move, with the low to mid 80s still on the cards for later 2013 or 2014.

Looking at the risk reward on this trade, if it were to prove correct, then we could be looking at approximately 300-350 points on the upside (And possibly more), with risk below last week’s 9137 low, therefore approximately 110 points risk at this time. I like this risk/reward on this trade, though dip buyers would naturally improve their odds. Waiting for a confirmed break, would bring greater confidence to the trade, however it would have a far inferior risk/rewards odds in my mind.

Anyway, third time luck for this year, let’s see what the summer holds. (Or winter if you reading this south of the equator).

'Money Management, Money Management, Money Management'

'Money Management, Money Management, Money Management' is to trading success what 'Location, Location, Location' is to determining the desirability of a property.

‘Money Management’ is the simple part of trading, yet it can have such a massive positive effect on a trader’s aggregate bottom line performance. - Time and again I come across traders (usually struggling traders), who fail to successfully heed the lessons of 'Money Management'. - Perhaps it is not surprising. - 'Money Management' gets no more than a brief mention in the trading literature; barely eliciting more than a few paragraphs, or perhaps an addendum at best. On the other hand, have you ever tried reading a book on Money Management, they are few and far between, and you'll be lucky if you manage to stay awake past the first few pages. - Therein lies part of the problem, 'Money Management' is not the sexy part of trading. - Finding a winning trading strategy for optimal entry and exit, finding a formula for the world’s greatest trading system which turns keystrokes into gold, gaining the right mentality to overcome the emotional battles, these get all the attention: How often have you heard someone talk about their excellent bit of ‘Money Management’ that day? Exactly! - Sure you hear tales of people ‘Who sold the top’, ‘Bought the low’, ‘Stayed with it’, ‘Doubled-up’, but I bet you don't often hear ‘I restricted the loss for the day to 1% of capital’, or how about a colleague telling you over a few beers, how they ‘position-sized so they could lost no more than x amount of $’, or they decided not to trade because ‘The Risk/Reward set-up was poor’. – Those discussions do not happen very often.

I was recently at a trader’s forum talking about trading and trading psychology, I was inundated with the people either asking me if I am using the right strategy, or where the market is heading. - All pretty meaningless questions without context, but when I asked them if they had a money management strategy, the best answer I may get was, 'I always use stops'. - That was it, the most important part of trading, the part that keeps you in the game and on track for success, reduced to – 'I always use stops.' – Trading seems unique, if most people started a business I am sure they would pay the utmost attention to cash-flow, liquidity, their incomings and outgoings, how much they can devote to expenditure and costs, etc. – Yet in trading, these basics are too often ignored. – There are exceptions, in many cases these are the successful traders who have been racking up the profits consistently for years. – I know of one very successful trader who told me ‘Money Management was everything, all else was subordinate to his money management’.

Steven Goldstein is a Behavioural Performance Coach who specialises in helping traders inside banks, hedge funds and investment management firms to help them improve their people's capabilities and performance. To know more about Steven's work visit the website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven directly on Twitter.

"Stock Chart" by nongpimmy. Courtesy of http://www.freedigitalphotos.net

Managing Human and Behavioural Risks within Financial Markets.

This article introduces some thoughts and ideas about human decision-making and behaviour risk in the financial markets. The article also asks questions of the financial risk industry and looks at whether it needs to put into place changes to take greater account of the human behaviour aspect of risk. Finally it looks at whether businesses can introduce improvements and enhancements to the way they work in order to prevent and mitigate risk, and to improve the quality of decision-making in the financial markets.

In John Maynard Keynes’s celebrated 1936 book, ‘The General Theory of Employment, Interest and Money’, he used the term “Animal spirits” to describe emotions which influence human behaviour. Now, some eight decades later, research from neuroscience is shedding light on these ‘animal spirits’, and in particular, how they affect people’s decisions in the financial markets. Some of these findings are leading to questions about some of the basic assumptions of how people think and act, and are also challenging long-held beliefs and tenets central to economic theory. Whilst this has some direct consequences for the field of financial risk-management, it also provides new thinking and offers potential solutions, some of which may help to improve risk-management practices and techniques moving forward.

The traditional view from classical economics sees people as rational, utility-maximizing actors; individuals who know what they want and are consistent, methodical, and emotionless in pursuing it. Consistent with this is the view of the human mind as a machine; working like a computer and rationalizing all options through the use of people’s cognitive powers, and the supremacy of intellect. Whilst these beliefs are cornerstones of modern economics, they are increasingly being challenged by the emerging fields of ‘Behavioural Economics’ and ‘Neuroeconomics’: Backed by a growing body of research, supporters of these movements argue that: Humans have many limitations to behaving rationally and that the use feelings and emotions (Keynes’ animal spirits) extensively when making decisions. As such these behaviourists call in to question many of the long-held theories and assumptions of classical economics.

An excellent example of the limitations of human rationality is provided by some research carried out in 2010 jointly by Colombia Business School and Ben Gurion University*. The study looked into the decision-making performance of a group of highly experienced judges at parole hearings in Israel involving over 1,100 cases during a 10-month period. The findings revealed some interesting and surprising outcomes. One would surely expect the judge’s rulings to be based on ‘rational-decisions’ undertaken within the guidelines established by written laws. Actually the biggest influence in the outcomes was the time of day each hearing occurred. Prisoners who appeared before the judges early in the morning session, or during the time shortly after the mid-morning break, or immediately after the lunch break, received the most favourable outcomes, receiving parole in about 60-70 percent of the cases. Whereas, if you were a prisoner up for parole late in each session, then you were in trouble: Prisoners who appeared towards the end of each session received parole no more than 10-15 percent of the time. The research found nothing malicious or unusual about the judges’ behaviour; rather they concluded the reason was ‘Decision-fatigue’. ‘Decision-fatigue’ refers to the deteriorating quality of decisions made by people, after a long session of decision making. ‘Decision-fatigue’ occurs as more choices are made throughout a particular period of time, and throughout the day. Particularly where decisions are complex or have more far-reaching consequences. This is because each subsequent decision becomes marginally harder as the brain draws on people’s energy reserves, principally in the form of glucose. The more decisions people make, the more their glucose reserves become depleted; as glucose reserves deplete so the brain modifies the way it functions to reserve vital energy resources. In these situations people do not ‘stop-thinking’, they just think less effectively: Modified thinking behaviours may include taking cognitive short-cuts, such as relying on simple rules-of-thumb, or perhaps avoiding making decisions altogether: Many people will have experienced ‘analysis-paralysis’!

Returning to the aforementioned study, no matter how rational and high-minded the judges aimed to be, they were fighting their own human biology: The depletion of glucose to the judge’s brains changed the way their thinking processes worked. In most cases, ‘the die was cast’, and prisoners who may have received parole had their case been heard at 9am in the morning, were more often than not sent back to prison when their case was heard around 3pm.

Whilst this study highlights the limitations to human cognitive abilities, other research highlights the extent to which our emotions play a role in decision-making processes, thus further arguing against the ‘rational man’ theory of classical economics: Renowned neuroscientist Antonia Damasio has done a lot of work to highlight the primacy of emotions as a key part of decision-making. One well-known study by Damasio showed how people who had received brain injuries in which they lost of ability to feel emotions, were incapable of making even the most basic of decisions; often spending hours deliberating over irrelevant details, such as where to eat lunch. Further research into the effect of human emotions in decision-making, has turned on its head the belief that the human mind uses purely cognitive processes to reach logical conclusions. Some people now argue that beliefs and existing theories of rational decision-making are being seen as increasingly implausible.

Coming back to financial markets, what are implications from these alternative beliefs for the field of financial risk-management? And what can the industry do to improve the way it manages financial risk?

Much of the focus of risk management in the financial markets is on quantifying and measuring

financial risk. A whole architecture of financial models, process and practices has arisen around this: The emergence of the Behavioural Finance movement does however question whether the financial risk management industry is on the right track. – The first question is whether the basic underlying assumptions that underpin some of these models are correct? The concept of ‘rational man’ largely underscores the long-standing view that markets are completely random, and that deviation from true value in liquid markets will be arbitraged away by ‘rational man’: Markets are however human constructs, driven by human perceptions, reactions and decisions, triggered by people’s emotions. Keynes understood the way markets worked from a behavioural perspective: In what was called the ‘Keynesian beauty contest’, he said, ‘you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher’. It may be a stretch to say that because people act and behave emotionally rather than rationally, that therefore markets are not truly random: However, it is this emotional human behaviour which leads to trends, manias, panics and long-term distortion from value, which are NOT quickly arbitraged away by the mythical ‘rational man’. - If markets are not truly-random, then this calls into question many of the risk-management models which themselves are based off this assumption, a situation which is further compounded by over-reliance on these models. Yet even if these models are correct or simply if they are the best tool for measurement available, the issue is that they are merely tools, they do not have any predictive capabilities, they are measurements of the amount of risk being taken, or the type of risk, but there is not much focus on the quality of the risk-taking or of the individual risk-taker. The financial markets are obsessed with measuring and quantifying risk, yet this has merely enabled a situation which has led to greater amounts of risk, and ironically larger and more damaging risk events.
 

Anurag Vaish of the 'Final Mile' consultancy, which specialises in finding risk solutions through neuroscience and behavioural economics, sums it up well: ‘Risk is a feeling not a number; financial Institutions are highly number driven and continue to represent risk more as numbers’. The work of the ‘Final Mile’ consultancy has yielded some excellent results in risk situations across a range of industries, helping to find unorthodox solutions to conventional problems. A good illustration of their work involved an experiment on a one mile stretch of the Mumbai Rail system which was notorious for deaths from people crossing rail tracks. After researching the problem, Final Mile came up with some innovative recommendations which took account of human decision-making and behaviour. When these recommendations were implemented, deaths from rail-track crossings on the stretch of line dropped from 23 in the previous six months, to just one in the next 8 months.

This article has shown how, when it comes to making-decisions, human behaviour is not necessarily in accordance with the common-held belief of humans as rational beings; we are not as in charge of our choices as we like to think we are: Our ability to act rationally and to effect well considered decisions is limited, and our emotions, such as fear and desire, as well as mood, have a far greater effect on our behaviour than we realise. No one is immune to this; even highly intelligent people and experts make poor choices. This last point should provide some extra context to some of the high profile examples of major financial losses within trading and investment businesses in recent years; e.g. JP Morgan, UBS, Societe Generale, Amaranth, etc. In addition there have been numerous smaller, but still extremely costly, financial losses which have impacted many firms, but which will have not made the front pages or breaking news stories.

What can trading businesses do to rise to the challenge? Working on improving the monitoring of and quality of decision-making, is not merely a matter of risk-control and risk-mitigation, it is also a pro-active endeavour which can yield businesses a greater return on investment. Steps could be taken to deliver improved robustness and quality in individual, managerial and group decision-making; practices in other industries could provide some potential solutions. For example, simple checklist practices have been put into place in industries as diverse as medicine and aviation, with profound effects on safety and quality. One piece of research showed that the introduction of check-lists on post-operative morbidity and mortality rates in one hospital saw a 57% decrease in complications.** Banks could include engaging trading managers, risk managers and supervisors through ‘what-if-scenario’ exercises. This is practiced extensively in the disaster-recovery industry and in the military. Many industries providing education, information sessions and coaching to participant’s engaged in dangerous and stress inducing industries: As part of its highly successful ‘Lamplighter’ programme, which aimed to improve employee wellness, Unilever offered a range of stress reduction programmes to employees facing high levels of stress, these included coaching and cognitive behaviour therapy to improve mental resilience. Whilst this was just one of a number of initiatives employed by Unilever, the programme saw an overall 40% increase in mental resilience, and the overall programme saw a large increase in productivity which equated to a 350% return on investment***. What about limitations to time at the screens? Many fields limit the time people can spend in high stress or highly engaged activities where human life is at risk: Aviation, transportation, surgery, they all place limitations on the amount of time practising in a day or a week. There is a valid reason for this; surely this can be translated to situations where people have huge sums of money and risk at their finger-tips.

Banks can also improve their monitoring of trading behaviours. Whilst risk management’s emphasis has largely been on quantifying the size of risks, they could easily put in steps to closely monitor trading behaviour: MI systems could be adapted to identify potential behavioural problems early, including spotting repeated patterns of sub-optimal behaviour, or signs of distress in trading P&L volatility that is outside of market norms. This can be taken further; businesses could look at their organisation or operational process to recognize organisation deficiencies in reporting lines, or to highlight limits of responsibility. Whilst, risk management could take a number of steps, it has to be cautious not to overly burden traders or be too interfering with the trading process at desk level. However, traders have a dual functionality, they are both risk seekers and risk managers, this in itself presents the first challenge: desk-level is the front line of risk-management. 

In the wake of the ‘Global Financial Crisis’, and subsequent strong political, regulatory and economic forces re-shaping the financial markets, the financial risk management industry is facing many challenges. It is unfair to apportion blame to the risk-management industry for the financial disasters of recent years; however it is right to question some of its assumptions and practices, and to find out whether things could have been done better and differently. As part of this process, it may help to step away from some of the beliefs of the past, and to see if new innovative solutions could be found and applied to take the industry forward.

© Copyright BGT Edge Ltd, July 2013.

*Extraneous factors in judicial decisions: Shai Danzigera, Jonathan Levavb, Liora Avnaim-Pessoa. Edited by Daniel Kahneman, Princeton University, Princeton, NJ, and approved February 25, 2011 (received for review December 8, 2010)
http://www.pnas.org/content/108/17/6889.full

** Effect of surgical safety checklists on postoperative morbidity and mortality rates, Shiraz, Faghihy Hospital, a 1-year study. Askarian M, Kouchak F, Palenik CJ. Department of Community Medicine, Medicinal & Natural Products Chemistry Research Center , Shiraz University of Medical Sciences, Iran.
http://www.ncbi.nlm.nih.gov/pubmed/21971026

***
Unilever Lamplighter Programme.
http://www.gbchealth.org/news/newsletters/2012/july/case-study-of-the-month-unilever/
 

"Right Or Wrong Decision Signpost" courtesy of Stuart Miles. -  http://www.freedigitalphotos.net".

"Risk Blocks" Courtesy of jscreationzs. -  http://www.freedigitalphotos.net".
"Risk Management On Laptop Showing Risky Analysis" courtesy of Stuart Miles. -  http://www.freedigitalphotos.net".

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