Behavioural Psychology And Your Trading Simon CoulterHead of Development and Risk Management MahiFX
About MahiFXMahiFX is an online retail trading platform offering clientsexceptionally competitive spreads and great customisablecharting functionality.Simon Coulter, is the Head of Development and RiskManagement at MahiFX and will be discussing the keyareas of human behaviour which can have majorimplications on your trading decisions. In the webinar, hewill discuss some practical examples of how to recogniseand address these issues.
Key Discussion Areas Of The Webinar• What is Behavioural Finance and why is it important to my trading/investing?• Discussion on the Efficient Market Hypothesis/Behavioural Finance relationship• Key areas of Behavioural Finance• Examining how knowledge of these (above) can increase our awareness of why the markets behave how they do, and help us adapt our trading/investing
What Is Behavioural Finance?Behavioural Finance is the study of the effects that social,cognitive and emotional factors have on economicdecisions and consequences those decisions may have onmarket pricing, returns and resource allocationBehavioural Finance and Market EfficiencyDoes Behavioural Finance research cast doubt over priorassumptions on market efficiency?
Key Behavioural Heuristics And Biases Anchoring Cognitive bias which sees people rely too heavily on initial pieces of information when making decisions causing subsequent judgements to be anchored to the information Examples include: 1. Current prices used as anchor in determining current fair values 2. Investment bank analysts and economist forecasts are often anchored around previous numbers and around other analyst consensus forecasts 3. Starting points of negotiations influence the negotiated outcome 4. Support and resistance levels can be traced to anchoring
How Does Anchoring Effect Our Trading Decisions?Anchoring can have a severe impact on our ability to givean objective probability on the likely outcome of a trade orinvestment leading to poor decisions about the risk inherentin trades/investmentsConservativenessThe tendency for people to cling to a view, closely linked toanchoring, it can be caused by overconfidence. Main resultof this is the under-reaction to new information
Some Key ConceptsConfirmation biasTendency to seek information, which conforms to our view,ignoring contradictory informationIllusion of validityTendency for people to think their views are more valid thanthey actually areCognitive dissonanceMental conflict caused when faced with contradictoryevidence, tends to see us seek conforming evidenceAlternative historiesObserved outcome was just one of a number of possibleoutcomes given the complex participant decision makingprocess at play
Conservativeness And Points To Consider With Our Trading1. Be especially mindful of confirmation bias when back testing trading rules, address the problems that curve fitting presents2. Seek out alternative viewpoints and information that run counter to yours3. Avoid scanning the world of technical indicators to find ones that back up your view, sticking to a smaller sphere may be helpful in this regard4. Try to increase your understanding of markets and the context within which events are developing5. Seek out the opinion of the majority it likely provides valuable information on what not to do, and how not to be positioned
RepresentativenessBias which causes us to estimate the likelihood ofsomething happening being based on how closely itresembles something else. It causes people to place toomuch weight on recent data. The heuristic helps us seepatterns in data and saves on computationIllusory CorrelationTerm that refers to our propensity to see patterns andcorrelation in random/uncorrelated events
Representativeness And Our Trading1. Relying too heavily on recent data can cause us to extrapolate recent movements2. Will assume future patterns will resemble past ones without having sufficient regard to context3. Can cause traders/investors to over-react to repeated bouts of similar news, when combined with conservatism (which often causes under-reaction) we can see large moves in pricing as people extrapolate the new results and attach them to their new model
Price Bubbles/Busts And Positive Feedback TradingExtreme cases where prices continue to climb then fall asnoise traders chase the trend. Noise traders will react topast price changes rather than any particular news per se.Encourages extreme cases of positive feedback tradingwhere buying/selling encourages further reactionarybuying/sellingTrend chasing and price movements from stop loss ordersare good examplesReflexivityPrices influence fundamentals, new fundamentals changeexpectations, further influencing prices creating a self-reinforcing feedback loop
Representativeness/Feedback Loops And Our Trading1. Prices do not rise forever, expect mean reversion2. Incorporate the effects of positive feedback and noise trading into your decision process when positioning and considering trade levels3. Be wary of price manipulation that attempts to create short-term feedback loops4. Be extremely wary of crowd behaviour during price bubbles, recognise that stringent discipline is especially critical during these periods
Over-OptimismIllusion of controlWhere people feel in control of a situation far more oftenthan they actually are. People often fail to distinguishbetween chance events and those that require skillSelf-attribution biasThe tendency for people to attribute positive outcomes totheir own skill and whilst attributing negative outcomes tobad luckRandom reinforcementThe tendency for people to attribute random outcomes toskill
Over-Optimism And Our Trading1. Don’t trade before you have the skill and necessary understanding to trade2. Develop a trading plan, critically evaluate performance against the plan, have another trader review the plan3. Don’t confuse randomness with positive expectancy4. Keep a detailed record of trades and evaluate that performance against your plan. This will help address our tendency to have a selective memory for winning trades and reduce random reinforcement
OverconfidenceClosely related to over optimism. Refers to propensity forpeople to believe they will be right in their forecasts farmore often then they actually areHindsight biasThe tendency for people after the fact to believe they hadpredicted the outcome beforehandSurvivorship BiasThe tendency for failed entities (companies) to be excludedfrom performance studies because they no longer are inexistence. Causes results to be skewed higher in studies,as only those which are successful enough to survive areincluded in the study
Overconfidence: Points To Consider In Our Trading1. Seek disconfirming evidence2. Never be 100% sure about anything3. Events in the market follow an improbable script4. Markets normally always go against the majority to the benefit of the minority5. Be aware of testimonials from marketers of trade package solutions, which prey on this bias6. Keep a record of trades and analyse them carefully
Equity Curve AnalysisTracks the performance of the system by analysing theequity curve to ascertain periods when our system is in andout of sync with the market• Allows us to track multiple systems with varying degrees of correlation allowing us to increase/decrease capital commitment to them as they move in and out of sync with the market• Enables traders to have more simplistic systems that are more flexible, less likely to be the result of having curve fitted while testing historical expectancy and will have a wider definition of favourable market conditionsNonstationarityKnowledge derived from previous statistics is less reliabledue to changing participants
Availability Bias, Framing And Prospect TheoryAvailability BiasPeople assess the frequency or probability of an event by theease with which they can think of examplesFramingPeoples behavioural outcomes and attitudes are influenced byhow given piece(s) of information are framedProspect TheoryPeople are far less willing to gamble with profits than losses
Availability Bias, Framing And Prospect Theory (cont.)Loss AversionPeople gamble with losses because we cannot bear to copewith losses so we will do anything to avoid themDisposition effectPeople are predisposed to holding losers and selling winnersStatus quo biasStrong psychological benefits brought about by taking noaction and avoiding loss realization
Points To Think About With Our Trading1. When entering a position ALWAYS put your stop loss in the system2. Think about your Risk/Reward ratio, don’t be too aggressive with your ratio, have adequate stop loss buffers3. Be clinical with loss realization, recognise its part of being in this business and not a failure per se. Confront any negative emotional responses to losses and develop positive behavioural strategies4. It is far better to gamble with profits than losses, letting your profits run allows your returns to increase exponentially, pulling stops to break even when in a profitable position (where it makes sense technically), and partial profit realization are effective ways to do this
SummaryThe field of behavioural finance whilst still subject toconsiderable debate offers valuable insight into the flaws inour decision making process and our desire for shortcuts.At the very least, knowledge of the ideas discussed todaywill help us as traders increase our awareness of thesebiases thereby introducing a more objective frameworkwithin which we trade.
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