Following the Crowd: Why we do it?

I love this clip from the classic 1960’s TV show ‘Candid Camera’. It rather amusingly emphasizes the way we as humans are prone to conform to crowd behaviour. There are many reasons for this, and it’s helpful to understand these when we try to understand markets, and our own behaviour within markets.

We all like to think we are independent thinkers basing our decisions on sound logical and rational choices. - However, this is not really how the real world works. - I am minded of a hedge fund client last year who lost a lot of money when the Swiss National Bank surprisingly devalued the Swiss Franc against the Euro. - He had actually wanted to be short of the Swiss Franc, which would have made him a lot of money, but instead was heavily influenced by the fact that all the senior portfolio managers around him, and the head of the firm, were the other way around. Thus he overruled his own analysis, and went with their view. Which subsequently came at a heavy price. - For those who have never experienced life in a trading room, this is far more common than you think. 

The Keynesian Beauty Contest

No matter how much we know, we are actually quite limited in our knowledge, and we know that, but only at a subconscious level: In financial markets, we can only ever have partial knowledge of all the relevant facts, thus 'subconsciously' we assume the crowd has far more knowledge collectively than us, and thus take notice of what they think. As a consequence, we submit a degree of our decision-making to the crowd, or at least the crowd that we belong to. This does not mean the crowd is always right of course, but that is not the point, the point is that we are heavily influenced by the crowd. As if to emphasise this, just take a look at the performance of Hedge Funds in recent years: They are considered the 'Alphas' of the investment world, yet since 2011 the US stock market is up around 70%, whilst US equity funds as a group are down close to 10%. Equity Hedge Funds have been herding around a bearish view for some time, Barry Ritholz discusses this in his recent article 'When “Fringe” Sentiment Dominates Psychology'. Jon Maynard Keynes first identified this when he compared the way investors pick stocks to how one could develop an approach for picking winners of a newspaper beauty contest (of the type common in the 1930s). In these contests, pictures of women would be displayed in a newspaper. The most popular selection picked by readers would be declared the winner. A prize would go to one reader, selected at random, from those who voted for the most popular choice.

"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees." 

(Keynes, General Theory of Employment, Interest and Money, 1936). 

This can help us understand why markets trend rather than just jump to a new level of value. Personally I can not think of a better reason to buy a stock than the belief that everyone else will be buying it. - On the other hand, when we are long of something and it is moving the other way, our negative emotional response is not just because we are wrong, it is also because we are feeling a little uncomfortable being against the crowd. The emotional response we are having at that point is not a choice we make, it is chosen for us by our ancient nervous system. - This happened because as a species we are social beings: Our ancestors learned to cooperate, share and be mutually dependent on each other, this greatly increased their chances of survival. Those ‘conforming individuals’ were the ones who came to pass on their DNA. Those who did not conform were more likely to be rejected by social groups. These 'rejects' would have to fend for themselves in the harsh natural environments our ancestors inhabited, which could mean almost certain death.  If you ever wondered where our innate 'fear of rejection' stems from, there is your answer. - For 'Fear of Rejection' also see 'Fear of Missing Out' or FOMO.

What about contrarians?

Fortunately as humans we are not completely hostage to our emotions, we do have the ability to 'learn' to temper our feelings, which allows us to modify our behaviours. Contrarians have become particularly adept at this. They are able to spot patterns where the crowd inevitably reaches an extreme. In trading, there is always an extreme for momentum, a point where the trade is crowded. At this point, if enough people exit together, the momentum turns the other way, sometimes with great rapidity. - Being a contrarian is an art, I know people who are always contrarian, they wait until they think the market is overextended then fight it. Many successful traders have made a career out of being contrarians, sometimes dicing dangerously with 'capital/liquidity death' along the way.

Good momentum traders on the hand prefer to go with the crowd. They are able to run with the momentum, and exit in a timely manner just as the contrarians are sharpening their claws. Good contrarians are excellent at picking extremes in the momentum, but bad contrarians actually help the trend, selling into a rising market not ready to turn, but then being forced to buy back at a higher level.

Successful trading and investing requires understanding not just the behaviour of the crowd (the market), but also a degree of knowledge of why as a trader you act and behave in certain ways. Successful traders develop behaviours which promote better decision-making, and counteract the negative and subconscious aspects of trading which so undermine performance.

By Steven Goldstein

Alpha R Cubed Ltd

Alpha R Cubed delivers cutting edge 'Behavioural Performance Coaching Programmes' which help traders and investment professionals learn more about their own 'Behavioural Biases'. Our powerful programmes facilitate people to transform their behaviours, leading to significantly enhanced performance and far stronger returns. If you would like to know more about our programmes, please click on the image below, or email me steven.goldstein@alpharcubed.com or at info@alpharcubed.com. Visit us at www.alpharcubed.com to learn more.

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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".

 http://www.freedigitalphotos.net"

 

Traders are never irrational, it’s just that our ‘animal spirits’ limit our rationality.

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.

Free images from FreeDigitalPhotos.net

SP500 V the AUDJPY

An ex-colleague asked me yesterday why I have not committed to the short-side of the market considering my recent bearish posts, I responded by showing him that I have also had a number of bullish posts and arguments too, and that I considered both have their merits right now even if I do not trust the upside. He countered with his claim that the upside just did not make any sense in his book as it was totally irrational. -- He walked straight into that one really; --  cue John Maynard Keynes famous quote:  'Markets can stay irrational longer than you can remain solvent'.  - He politely backed down.....  

Today's post is going to look at the relationship of the SP500 and the AUDJPY fx cross. The AUDJPY fx cross has been one of my favourite barometers of risk appetite, its moves have been very closely correlated with moves in broader US equities for some time now. The first chart shows this close correlation has existed since around 2003 now. There have been some periods of directional divergence though these have been few and far between, the most obvious being H1 2008, though this eventually came back into line.

Over the course of this year the directional (not magnitude) correlation has remained strong. This can be seen on the daily chart below. However over the past two weeks there has been a strong divergence between the two. The AUDJPY has remained very benign lately moving in a tight sideways band, meantime the SP500 has gone from strength to strength. I assume that what is happening is an adjustment due to expectations of QE2, however if this is not the case, then should the AUDJPY fail to break out sharply to the upside soon, then perhaps the SP500 may realign itself with a sharp correction (one to watch I suppose).

The next chart shows the AUDJPY on its own with the MACD over the past year. I have highlighted the current sideways consolidation and the 2 prior similar consolidations from this year, together with their MACD indicators. There is no guarantee that just because we have 2 previous similar patterns, that a third similar pattern will produce the same result, however I think it is worthy of consideration. Note; the strongest similarity is with April this year. - I would point out that there is no hard and fast rule as to which way these sideways correlation typically breakout (absent of a an extended prior trend), or how long they can last.

I do not have any sort of recommendation based on the above, but I do think it is something else to keep an eye on in trying to gain an understanding of the bigger underlying picture.