Behavioural trading is the nimble offspring of two well-established parents: behavioural finance and opportunistic trading. From the former draws insights that show how and why traders can behave irrationally, while from the latter takes the notion that these irrationalities can be turned to profit.
But while behavioural trading has some features in common with contrarian trading, the two are quite distinct. Contrarians believe that, when markets swing too far one way or the other, traders have “got it wrong” and you rarely lose by betting against them.
Behavioural traders take a more nuanced approach, seeking clear evidence of irrationality before acting, rather than assuming that a strong market trend provides all the evidence needed. To find this evidence, they use the thinking behind behavioural finance.
Follow the crowd
What is this ‘thinking’? In short, it argues that classical economic theory, which states that people will always act to maximise their material standing and will do so rationally, is wrong, and that irrational behaviour is commonplace in financial affairs.
It follows from this that the “efficient market theory”, which holds that prices at any one time reflect all the available information about the security in question and are therefore rational, is also wrong.
Some refer to these categories as “biases”, which is a good description given they tilt the trader away from the most profitable course of action. Let’s start with one of the most common, the bias that leads traders to follow the crowd.
The “word from the herd” is one of the most powerful influences on traders, and can hold sway even when, rationally, they know the crowd is heading in the wrong direction. There are any number of jokes about stockbrokers who, having spread false gossip to mislead their rivals, end up following them on the basis that “there must be something in the rumour”.
Then there is “confirmation bias”, the unconscious habit of falling on pieces of evidence that would support the trading strategy while screening out those that do not. Similar to this is “attribution bias”, in which successful outcomes are entirely the result of the trader’s skills.
Loss feared more than profit prized
Attribution bias has long fascinated academics, and has prompted a great deal of study. Beyond the trading world, it has been seen in, for example, the tendency of a local business to be given credit for the good it does in terms of job creation and shareholder dividends while anything that goes wrong, such as a factory accident, is put down to bad luck. By contrast, a foreign-owned firm gets little credit for the good it does, this being assumed to be a matter of fate, but is blamed when something goes wrong.
This tendency to credit either ourselves or entities of which we approve, while giving none to our rivals or entities of which we disapprove is known as the “primary attribution fallacy”.
The “sunk-cost” bias is a variation on the timeless theme of throwing good money after bad. It is linked to loss aversion in that the trader, having sunk a certain amount of capital in a particular trade, is determined to hang on until it “comes good”.
Sunk-cost bias can be especially pernicious because it is self-reinforcing. The more time and money that is invested in a particular trade, the more reluctant will be the trader to admit defeat. Sunk-cost bias leads traders to ignore the fundamental rule of the market – run profits, but cut losses.
A brace of biases that are closely linked comprise “the endowment effect” and “familiarity bias”. The former describes the tendency to value what we own above what we do not. Experiments have shown that, given a cheap coffee mug or similar domestic article for free, the subjects generally refused to sell it for cash later.
The latter, as the name suggests, biases traders towards assets and strategies that they know well, even when there is every chance that alternatives would prove more profitable.
Our first two biases – following the crowd and confirmation bias – can be seen as biases that can lead the trader to embark on sub-optimal trading strategies. The third, attribution bias, encourages them to continue, by taking successes as proof of the correctness of the strategy while minimising failures.
Loss aversion, sunk-cost bias, the endowment effect and familiarity bias are four biases with one over-riding manifestation – staying with a trade or a strategy for too long, beyond the point when pulling out would have been the rational course of action. These four are also the biases of most interest to opportunistic behavioural traders for the simple reason that they are the easiest to detect and to act upon.
The last two fall somewhere in the middle, in that they take place in the trader’s mind but can be detected in action by experienced behavioural traders.
So, are the behavioural traders immune to the same biases as the rest of us? Of course not, they are only human. But they are aware of them, which gives them an edge. They have followed the advice attributed to the Greek philosopher Socrates: “Know thyself.”