Behavioral Insights: A Potent Factor in Understanding Markets

Brief

Behavioural finance and economics is a relatively new field which has suddenly emerged as a threat to the traditional schools of thought. The main difference is the integration of economic concepts with the logic and emotions of human beings. There is no empirical evidence where the numbers tell you a particular theory is true, rather, it is purely based on observation of the human race and analyzing their thoughts and decision making process.
As an investor, trader or observer, how do you usually contrast between an organic and inorganic movement? It is quite difficult to answer that off the top of your head, but if you were to look back at moments where you were observing the price of a market or security, you would be able to very easily find the pattern.

Basis

Richard Thaler, the father of behavioural economics, describes traditional economics as the ‘the study of econs’. He theorizes that by ignoring observations of society and the importance of the emotional factor in the decision making process, traditional economics is a study of a species called ‘homo economicus’.

Daniel Kahneman and Amos Tversky are world famous for presenting ‘prospect theory’, a psychological phenomenon that proposes that losses affect individuals more than gains. Losses create a greater stress to gains that create a sense of happiness. For this reason, they concluded that by nature, humans seek loss aversion. In my opinion, prospect theory is 100% correct and needs to be overcome for success in markets. If you look at one of the most vital characteristics a person must possess to be a trader or investor, it is the ability to stay mentally strong after a series of losses (or one big loss). This is essentially overcoming basic human nature linked to prospect theory. It requires a lot of discipline and months (usually years) of mental conditioning.

Orders of Thinking

One of the most useful concepts in Richard Thaler’s book ‘Misbehaving’ is that of second and third order thinking. Let me explain this with an example. Your friend tries to sell you a chocolate bar worth $3 for $2. First order thinking is thinking “this is a pretty good deal”. Second order thinking would lead to “he’s trying to pull a fast one on me, something is wrong with that chocolate bar so he’s willing to push it on to me for a loss”. Third order thinking builds on this and one would think “everyone is going to think this is a shady deal since he’s willing to incur a loss for this sale, but what if he is need of money or doesn’t see the real value of this deal and is unknowingly underpricing his chocolate bar”. This order of thinking is what leads many people to have polar opposite views on a particular subject.

Price Action

Price action can actually be explained by behavior. In any market, the mindset, behavior, and overall psychology of each participant plays an essential role. Now just a simple exercise.

A quick look at these charts and the first thing you see is manipulation. This was precisely the notion most traders had which is why we had instantaneous reversals. The upward manipulation was the Tether sell off in October while the downward manipulation was in late September, caused by a volume influx.
The most used and effective price action analysis method is by using the Elliot Wave theory. Theoretically, it involves moves of 5 or 3 waves, but practically, we don’t always see moves with 5 or 3 waves. For the sake of ease, I’ll explain it with the theoretical Elliot Wave scenario

This is the layout of a trademark Elliot wave chart- 5 wave upward impulse with a 3 wave downward corrective move. Up until ‘5’, everything is fine as the price goes up with small corrections to gather liquidity. ‘5’ is the point where the perceived value is much lower than the price, so a sell off commences.

People who don’t understand price action analysis will get entangled in this region and not keep up with the behavioural dynamics, leading to losses. After reaching 5 when we cool off, people see this as just another small correction for liquidity before going up again. It isn’t until the ‘C’ wave crosses the ‘A’ that people realize the market is bearish. From the start to the end of the red arrow, we see a lot of accumulation despite selling pressure, eventually, the selling pressure ends at ‘A’ and accumulation continues. From the start to the end of the blue arrow, we see accumulation continue, but a lot of participants who bought at very high prices, exiting for a small loss. This exiting causes the market to make a downward move. People who analyze charts or price action will see this as the reversal and final ‘C’ move down and start to short or sell their positions. This perception from large traders causes the move to commence.

If broken down to trend lines, Fibonacci retracements, key levels, and other indicators, all of them can be essentially explained using human behavior. No matter which corporations or institutions are behind a market move, at its core, each of those entities comprises of a group of human beings and/or robots and algorithms built and controlled by human beings. Therefore, their actions are indeed predictable, if seen in the right light.

Conclusion

Behavioural insights can be used to explain or attempt to predict any markets. Predictions cannot be fully accurate because behavior isn’t something consistent- it changes with each piece of news or statistical information. It is important to keep up to date in such a dynamic environment to make sure you’re a step ahead of the market; or with third order thinking, two steps ahead!

Sources

• Charts prepared on TradingView
• Behavioural study based on the teachings of Richard Thaler, Daniel Kahneman, and Robert J. Shiller