Behavioral Finance and Cultural Arbitrage

I have been reviewing materials from a seminar attended by one of my colleagues in the finance industry. It begins with an attack on the rational investor and goes on to discuss how trends can be used to predict market behavior. Not the stuff of a conventional economics education.

It throws away the myth that investors have great predictive powers over financial markets. In fact, most investors make winning trades a little over half the time. If this isn't bad enough (seeing as these people manage the funds that you plan to retire with) they often tend to be profit adverse and risk seeking.

The explanations for investors running away from profits lie in human psychology. People are more than happy to take profits wherever they come. After all, "You can't lose money by taking profits, can you?" Well yes, you can. If you sell your investment after a 10% gain yes you make money. But if your investment goes up another 20% after you sell you are giving up that money.

The psychology of losing is more interesting. For various reasons, loss of self respect, status, or even your job, people just don't like to admit when they've made a mistake. So they compound it and stick with their losses, hoping to turn them around. In the process they end up losing a lot more money than if they sold early at a small loss. The moral of the story: pick a trading strategy (trend, mathematical, or discretionary), set targets before you trade, and stick with 'em.

A last note which may or may not be relevant for those of you concerned with profits more than overt wonkiness. This paper holds that high and low prices, resistance and support levels, are fixed in investors minds by past trading patterns. It takes a minimum of THREE troughs or peaks to set these prices. Why three!?!

Well as my former anthro professor, the late Alan Dundes, would hold, this is for the exact same reason that God has a tripartite nature, everyone makes three points in their speeches, and every joke has three guys walking into a bar. For us, three is a 'native category' a basic cultural reference point. It's unit of measure that we all have agreed can size up all manner of otherwise noisy information. Why did we pass a 'Three Strikes and You're Out' law in California? Because we've all agreed that that is enough chances.

But go to China and you'll find a native category of five. So five people in the jokes, etc. This would suggest that Chinese traders would require more troughs and peaks before support and resistance levels are set. This points to a possibility of potentially identifiable widespread trading biases.