Bases of behavioral financial analysis

by Peter Greenfinch

This article intents to throw some light on asset market prices behavior

and illustrate that point by showing how price trends take place.

1. Market efficiency or fanciful behavior?

  What produces stock prices?

Stock prices result from the situation and the prospects of the economy and the
businesses, isn't it?

Come on ! Not so fast ! What produces those prices are buying and selling
decisions of zillions of investors, big ones, small ones, average ones.

Why would you expect that their decisions, often made in a hurry, or on the
contrary too late, on the basis o
f information they do not really get or grasp,
reflect perfectly those prospects

OK, the investor is supposed to base its decision on the stock expected incomes,
therefore on those prospects, to decide his buy and sell operations. But, when
you buy a garment that you like, do you first check if you will get your money's
worth, under the criterion of the fabric's durability?
And if you buy a car, is its annual budget your main criterion ? Which car owner
has more than a vague idea about it?

Don't tell me that it is different for professionals. They are the first to contaminate
one another in following trends (a synonym of fashions
, we should never forget it,
so as to try not to go astray of the "consensus" of their colleagues.

Biased behaviors, market anomalies, and how to use them

Behavioral finance (BF) studies the individual and collective biases among
investors, and their influence on market prices.

It takes into account that investors are not fully "rational" in their decision
People are under influence. Even more when money is at stake, a situation
propitious to fantasies and illusions.

This is why behavioral finance:

  identifies cases in which those irrationalities  - or those bounded rationalities -
distort the understanding and behavior of market players. A useful knowledge
for all investors, those traps that their own mind puts on their way.

  studies how those biases create market inefficiencies in the form of price
and return anomalies.
Yes, sometimes the market makes idiocies, happens to anybody.
Not easy to have a grudge against the market, as it is us who help it make
those idiocies !

Behavioral market analysis (BA - BMA) is a practical application of BF.

BA tries to spot those price distortions and to find the causes of those
mispricing case by case. The purpose is to see better the risks and the gain
opportunities so as to take advantage of them.

How do we spot a price anomaly?

This is not too easy if we take as reference the future prospects, always tricky
to estimate. Even so, let us say that those anomalies are deviations between
the market price and what is supposed to be the intrinsic value calculated with
traditional mathematic models. Those models are based on the EMH /  efficient
market hypothesis. Unluckily, the EMH reflects poorly market realities, even
if some "degree of efficiency" might exist.

What is the EMH / Efficient market hypothesis?

The EMH is a belief based on the following assumptions:

Investors are fully informed,

They are rational, therefore they interpret correctly that information,

Their only motivation is to maximize their financial utility,

They think, decide and behave in all independence (they would not mimic one
   another to shape their opinion and make their decisions),

Their decisions lead to a price equilibrium, an "efficient price", rather stable
   in the absence of new relevant information, but which vary immediately, to
find a new equilibrium, when such an unexpected relevant information occurs.

All in all, the EMH considers that the market's pricing of an item, thus for a stock
its current market price:

  is the best estimate of its value

  is the exact and full reflection of all available information

  adjusts immediately and correctly each time new information arrive.

The EMH supposes every investor is a genius who knows all the facts, interpret
them correctly, uses them independently, and makes a time discounting for
projected earnings to arrive at:

 ideally, the same price that all other investors

  or a bracket of individual estimated prices due to each one's utility
coefficient (individual sensitivity to gain / risk prospects). This range of
buying / selling proposals will create a stable supply / demand balance
(in the absence of new meaningful information) in the market, with a
rather stable price.

The EMH is also related to the concept of the random walk of market prices.

As a kind of apology of amnesia, the RW hypothesis states that prices have no
memory and yesterday is unrelated to tomorrow. Past prices records cannot help
to predict future prices or to time the market. But the many competing investors,
who do not necessarily act at the same time, make that the price cannot be fully
stable. There

  Prices should wander softly at random around its equilibrium level.

  This optimal level would change from time to time, in a random way
again, as soon as new crucial information appears.

  In practice, that would mean that we have full randomness and that
market prices are unpredictable.

The main types of psychological biases

Research has shown, this is our cultural sequence, that the price anomalies
compared to the EMH result, aside some technical aspects (lack of information,
of liquidity, of homogeneity in the market), are due to four main types of
psychological biases:

1. Individual cognitive biases (= understanding, recalling and reasoning

2. Collective cognitive errors (affecting all investors or some types of
dominant ones)

3. Individual emotions and passions

4. Collective emotions and hysterias (group and crowd behaviors).
point of social psychology is, between you and me, an exciting topic
   for whom  wants to avoid to be manipulated. It should be part of civic
   teaching at school.

2. What causes price trends in asset markets?

What is a trend, a price momentum?

Look at a stock market price evolution graph. What strikes the eye is ... ...that it
wriggles a lot. As we say, things are "volatile".

Now, look at the painting from a little afar, scan the landscape instead of the mess
of brush strokes.

Then you see that prices follow often a rather precise direction. After a while,
  they have gone up, down or stagnated (a platitude, I know).

A bit more surprising, you notice that, although they wriggle, their zigzags
  usually stay inside a road that we can often mark out by drawing two (more
  or less) parallel straight lines.

Depending whether that road ascends, descends or stay horizontal, it is called a
bull, bear or neutral channel.

Careful anyway not to fall into the trap of an excessive trust in graphic analysis,
also called technical analysis (TA), we will talk about it further below. Some of
those channels might be optical or mental illusions, produced by a
representativeness heuristic a mental bias that sees patterns everywhere.

It makes think of those kids magazines in which, by connecting the dots, we draw
a cow or a car.
Random oscillations might give the impression to obey some hidden order.

From time to time, a new road, often in the opposite direction of the previous
one, gets drawn (or seems to get drawn, always the same reservation).

There seems to be alternating periods (sometimes called cycles) of several
months or years of rise, fall or stagnation. Trends (or cycle-trends), are
those big tides, which strength and direction are called the price momentum.

  Aren't those tides weird?

What come first to mind is that those long undulations match economic or
interest rate cycles. It is sometimes true, but not always, and even then there
are lags or leads. Anyway, why would they  match them? Everybody knows
that the economy is alternatively buoyant or depressed and that all those
moves should average out in the long term. Therefore prices should fit the
average prospects, no?

OK, I agree with you, for a given firm, in a moving environment, news that
change prospects are rather frequent. But even so, prices should move only
in case of a good / bad  new that is totally unexpected, the breaking news
that change in a clearly fundamental way the business future. Then, prices
should adjust at once, and basta

If the next information goes in the same direction, we could say that there
is nothing new, we could have expected it. Why should prices move again?
Even more surprising, we see that, even in the absence of decisive news,
prices move most of the time in a way that helps the trend to persist.

  Investing traps in using information

Reaction to information has a crucial role. Investors have problems at chewing
gum and analyze info at the same time.
They perform, let us play the Sigmund game:

Heuristic limitations.

This means that they analyze and decide on the basis of too skimpy elements.
Heuristic is a guesswork tool that we manufacture ourselves in advance so as
to decide a rapid move when an event occurs. With simplistic rules such as:
if the pan burns my hand, I put it down. While forgetting maybe that the baby
had just put its tiny hand under it.

Mental anchoring.

They keep somewhere in their gray matter some points of reference, often
recent facts (short memory) or sometimes older ones. For example a past
market price that they deemed relevant.

Cognitive dissonances and denial of realities,

In other words the tendency to play the ostrich by rejecting the new facts that
contradict their beliefs / preconceived ideas.

Habits, such as, every morning, I give buy and sell orders, even if I do not
  have very precise ideas.

Simplistic common denominators. under the effect of mimicry (we will talk
  again about it below).

Social behavior is largely based on conventions and paradigms (trendy mental
models) that are common to everybody.

Underreaction and overreaction: the most common trap
   that might explain trends

All this leads the stock market into a four step waltz between the start and the
end of a trend:

1. One day, an information that differs from the past falls from the sky. It is
often a weak signal (often the case for advanced signals). Often, as good
ostriches, investors, conditioned by the recent past,  do not see it, neglect,
make fun of it, or reject and deny it. As few people use the information to
change behavior, the previous trend persist (the previous over-reaction goes
on, see the dance step #4).

2. Then there is a moment when the signal, by staying present, or by getting
reinforced by new signals, is perceived at last by investors. They deign
to put their glasses and to start to adjust, but still timidly, their past references
and their behavior. Under that modest mental adaptation, the trend starts to
decelerate et to have hiccups, but just a little (under-reaction).

3. When, little by little, this information gets confirmed by new ones going
in the same direction, investors adjust better their references, progressively
or suddenly and drastically. They get carried away by he new atmosphere.
They play fully the new trend, which therefore settles in for good. This is the
adjustment phase.

4. Then the trend persists and gets amplified, whether there are or not new
confirmation info. The only data that interest investors, are prices, and their
evolution shows them that the market trend stays alive (for the time being).
With the help of fear or greed (see further below), this convince them that
the trend is justified and thus ...will go further.

They adjust again their references, this time in excess (over-reaction). They
rationalize, in other words they invent good stories to justify that everything
will go on in the same direction. And they add fuel to the market (bringing
money in bullish periods, assets to sell in bearish ones) which accelerates
the trend.

We will talk again below about the distortions et inefficiencies that this reflexivity
due to mimetic rational expectations. A priori, this is an anomaly. At the same
time it is not: it can seem productive for an investor to follow the trend, even if
he knows that he takes the risk that it reverts one day.

  Force of individual and collective emotions
     to create and maintain trends

Greed, fear, self love, love itself, admiration, enthusiasm, disdain, hatred and
    many more other passions (remember classical theatre, or news items) condition
    the investors' actions.

Those passions are not only individual phenomenon. Social psychology shows
that they are contagious. In a group, and above all in a crowd, individuals
become easily fierce ... sheep (herding, mimicry). They tend to lose their own
references, to share common creeds, to heat up between them their collective
emotion, and to move together in the same direction, at the risk to run into
The gregarious virus produces:

either light symptoms: stock market fashions; oh yes, in the garment
business, trend and fashion are synonyms.

or true illnesses (bubbles and crashes), when the emotional contagion
reaches collective hysteria.

Moreover, people easily accept obedience to authority, even to the apparent
authority that experts seem to have. The star system is also found in stock
Some analysts, journalists, experts and business leaders acquire a guru status.
Whether they are intentional or not, manipulations, ordinary stuff in interpersonal
relations, take their full dimension in groups and crowds, which are more easily
influenced than individuals alone. That is how market trends heat up and stay hot.

  And here come the romance of feedbacks. Let us analyze a little more the
"mimetic rational" expectations and the market reflexivity. A vicious circle
(positive feedback loop, to sound more academic) takes place when

the previous action gives an excessive outcome (overshooting, we sent
the ball outside the playground),

but it does not lead to an opposite reaction (negative feedback =
subtraction, the next time, we shoot nearer) that would stabilize the system,
here the market prices, by making it vibrate gently around a mean (short
term volatility),

on the contrary keeps and amplify to excesses its deviation (positive
= addition, we shoot even further, we have what economists call
the "law of extremes").

In stockmarkets, it happens also that the belief change is largely delayed. Until the
accumulated bullish or bearish pressure triggers the change in the form of an
avalanche, starting a crash or an exuberant bubble. A trend that self-sustains, until
it breaks in its turn in a reverse craze.

Even professional analysts (taken as a group) become more plus optimistic /
pessimistic after prices have raised / fallen. It is only then that they adjust their
previsions. This revised consensus causes prices to rise / fall again. This leads
again the bulk of those "experts" to raise/ lower their earnings expectations, etc.

Often the reasons seems to be that a poor lone analyst (unless he has very privileged
private information) hesitates to be the first to publish a recommendation that goes
against the current consensus. Because he would risk then to obtain results that diffe
from those of its colleagues. If an analyst is wrong with all the others, he will be

forgiven, people would say things were unpredictable. But if he is wrong alone,
rope to hang him is ready.

  Is fear a good counsel? Anyway, it distorts trends

Even greed and fear might be biased in only one direction. It was discovered
(prospect theory) that loss aversion is stronger than as well greed as simple risk

People often refuse to accept their losses and they keep assets which evolution
was disastrous.
They therefore take the risk that they fall even more. It is much later that they
might throw in the sponge, when the fall is so deep that they are seized by panic,
and decide to sell ...often when prices reach their lowest level.

That might also explain why downside volatility is often plus higher than upside
Here again we use academic words to say that panic is contagious in a faster way
(crashes...) than euphoria. People sell massively all items on which they still have
a gain, so as not to lose money on it, and only at the end all those on which they
lose their shirt, for fear that soon they would be worth nothing.

   Let's go to our tools: valuation, timing

Extreme potential prices. Those upwards and downwards alternations can bring
prices from one extreme to the other. This happens as well to the market in general
as to about every category of stocks (some, as rare species in the ecosystem, do not
always follow the general move).

My maxi / mini "image coefficients" take into account the split done by the stock
dancer, andhelp to estimate potential prices at the start and the end of the trend,

Technical analysis (TA) is a tool that is based on the idea that markets have some
And that therefore, past prices, or the current price momentum, can give can idea of
price future evolution. TA aim to detect if the trend (therefore the current investor
behavior) will persist or make a V turn.

TA gives some results. But it can also disappoint as it put its trust on graphic signals,
pictures that are rather often tangled up (the famous price wriggle), unclear and
Therefore it should always be combined with other decision elements. In fact, TA and
extreme price estimates are rather complementary ....although that combination does
not avoid all surprises.
Yes, we must admit that the the stock market keeps being a game and that we should
avoid to commit tomorrow lunch money in it.

An interesting trick, although not too easy to play, is to try to detect the
accumulation-distribution phases that appear sometimes at the start, or the end, of a
price rise or a price fall.
It is when the big hands start to buy from or to sell to the small pigeons who still
believe that the trend, which in reality is dying, will persist. They believe it all the
more if  (disinterested?) gurusgo on disseminating that illusion.


Dern. mise à jour cette page 23/11/14         
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