Is Market Behavior Driven by Human Psychology?

[Q-1]

I have a question that's bothering me.

Namely, externalities aside (et ceteris paribus) humans are still the main component of rational actors in the marketplace, then if we perfectly understood human psychology, then would the market be perfectly predictable and understandable?

 

[ZeGato]

No, and one of the reasons is that marketplace participants aren't an homogeneous group. Each participant has their own motives for trading - for example, many companies trade future contracts to hedge investments, whereas others trade them for short or long-term profit. And even if we perfectly understood human psychology AND knew the goals of every participant at any point in time, it still wouldn't be predictable, since any prediction would influence participants' actions in a never-ending loop.

 

[russ_watters]

Namely, externalities aside (et ceteris paribus) humans are still the main component of rational actors in the marketplace, then if we perfectly understood human psychology, then would the market be perfectly predictable and understandable?

Not if there are still significant components of irrationality and unpredictability (I was thinking "random", but that is probably too strong).

Note also that there is nothing special about rationality here: people can be predictably irrational.

 

[Q-1]

No, and one of the reasons is that marketplace participants aren't an homogeneous group. Each participant has their own motives for trading - for example, many companies trade future contracts to hedge investments, whereas others trade them for short or long-term profit. And even if we perfectly understood human psychology AND knew the goals of every participant at any point in time, it still wouldn't be predictable, since any prediction would influence participants' actions in a never-ending loop.

Not if there are still significant components of irrationality and unpredictability (I was thinking "random", but that is probably too strong).

Note also that there is nothing special about rationality here: people can be predictably irrational.

But, over time wouldn't market behaviour converge on what is most rational if irrational behaviour could be foreseen based on knowledge of market psychology? I'm under the impression that speculative and such types of volatility trading would recede towards trading based on fundamentals and arbitrage trading.

 

[fresh_42]

The only possible answer is no. You've already read some fundamental reason for it: different targets, human behavior, inhomogeneity. In addition we have, and that is crucial here, very diverging levels of information, and by the way as well costs. Furthermore, there will be natural and political disturbances which are impossible to predict. You will have to make so many assumptions to derive a model, that the result will be exactly this: a model under idealized conditions. Add yours to the hundreds we already have.

But, over time ...

What does that mean? Until the law of large numbers takes place? Considering the modern trade mechanisms, aren't we already there? Anyway, how much time is time?

... wouldn't market behaviour converge ...

It already does. It's called daily fixing.

... on what is most rational...

Undefined. Assumption.

... if irrational behaviour ...

Again undefined.

... could be foreseen based on knowledge ...

Assumption, that such a knowledge can be achieved.

... of market psychology?

No. And if all the above didn't convince you, here are two further objections:

• Supermarkets already work this way. Nevertheless, they cannot precisely predict consumers behavior, for otherwise they wouldn't waste so much goods and thus money day by day.
• The pure number of variables, initial conditions, prize building relevant events are way beyond any current possibility to handle.

I'm under the impression...

Opinion.

... that speculative and such types of volatility trading would recede towards trading based on fundamentals...

That's what economists dream of. In reality, this is another, and in my experience, completely wrong assumption. To buy 500,000 IBM on Monday and sell them on Thursday has absolutely nothing to do with fundamentals. But despite of this, it's analysts' daily bread and happens all the time in countless offices.

... and arbitrage trading.

Again an assumption. Arbitrage trading takes place, but rarely leads to an equilibrium as theories assume. Have a look on such a simple thing as currencies and compare the Euro prize in Chicago with the Dollar prize in Frankfurt on single days. Not to mention the time lag!

 

[Q-1]

@fresh_42 , thank you for your enlightening response. I guess I have nothing to add here, so I'll be watching for more enlightening responses on the topic.

 

[fresh_42]

@fresh_42 , thank you for your enlightening response. I guess I have nothing to add here, so I'll be watching for more enlightening responses on the topic.

There do exist models which try to solve this in similar ways. E.g. game theory is an entire area, which deals with such models and its applications in fields as economy, biology or similar. Decision theory is part of the economic curriculum. But they all have to make assumptions. In decision theory, e.g. it's taken into account how risk averse deciders are. And that is only one aspect of humans' decision building process. The psychological view adds even more. In addition, more and more trades are done automatically by computers. How will you include this vast part of trading into a model based on human behavior?

 

[Q-1]

game theory

Going slightly off-topic or voicing my opinion... I think, that it's beyond the scope of game theory, decision theory, and any type of modelling theory to try and capture the essential aspects of human behaviour to predict decision making. I'm reminded of the tale of the man who tried to write down his daily activity, that takes him a week to put on paper. A super-task if you will. I think that three-dimensional analysis of trading addresses this issue in part; but, you can't (or I don't think so at least) really squeeze in human behaviour into a two-dimensional semantic plane that is the economy.

 

[BWV]

I have a question that's bothering me.

Namely, externalities aside (et ceteris paribus) humans are still the main component of rational actors in the marketplace, then if we perfectly understood human psychology, then would the market be perfectly predictable and understandable?

The first sentence does not make sense to me, what other actors are there other than humans?

Why should we believe that human psychology plays the primary role in driving changes of stock prices? You cannot demonstrate this empirically, it is just a story people make up to the explain stock price changes ‘stocks reached a resistance level due to investor profit taking ...’. That stuff is just bullshit the financial press makes up to sell papers or get clicks.

If you perfectly understood human psychology how would that make markets predictable? Stock prices are driven by only two things: expectations of future earnings and discount rates, and of those two, the discount rate is by far the greatest contributor to volatility. Psychology has some impact on how people form these expectations and there are well documented biases that exist, but understanding that does not help you predict whether or not the economy will be in a recession a year from now

 

[phinds]

I have a question that's bothering me.

Namely, externalities aside (et ceteris paribus) humans are still the main component of rational actors in the marketplace, then if we perfectly understood human psychology, then would the market be perfectly predictable and understandable?

If we "perfectly understood human psychology" one of the most important things we would find out (and that we really already know) is that humans are unpredictable. The same stimulus on one day will NOT necessarily elicit the same behavior on another day. You are, I believe, wasting time with such a theory.

 

[Q-1]

The first sentence does not make sense to me, what other actors are there other than humans?

Umm, there's algorithmic trading, along with high-frequency trading done by computers. I believe the fad of high-frequency trading is fading away with some significant losses incurred by such decision making.

Why should we believe that human psychology plays the primary role in driving changes of stock prices?

Because speculative trading is alive and well. Just to take the last couple of days on the US stock market as an example, uncertainty and volatility have led to significant losses on the stock market. All, of which is due to well, in my humble opinion to human/market psychology.

You cannot demonstrate this empirically, it is just a story people make up to the explain stock price changes ‘stocks reached a resistance level due to investor profit taking ...’. That stuff is just bullshit the financial press makes up to sell papers or get clicks.

I believe the last couple of days on the stock market just demonstrates this fact. Please correct me if wrong, as that's entirely possible.

Stock prices are driven by only two things: expectations of future earnings and discount rates, and of those two, the discount rate is by far the greatest contributor to volatility.

I'm not sure what's the "greatest contributor to volatility".

Psychology has some impact on how people form these expectations and there are well documented biases that exist, but understanding that does not help you predict whether or not the economy will be in a recession a year from now

Well, I believe that the majority of the market is occupied by people, who have differing psychologies. Those psychologies seem to contribute to stuff like speculative trading, shorts, bubbles, and market corrections.

 

[Q-1]

You are, I believe, wasting time with such a theory.

I might as well be. But, it's the internet after all. I'm glad I don't invest in the stock market. I'd be poorer than I already am with my pie in the sky theories.

 

[russ_watters]

But, over time wouldn't market behaviour converge on what is most rational if irrational behaviour could be foreseen based on knowledge of market psychology?

That's a self-contradiction.

 

[russ_watters]

You cannot demonstrate this empirically, it is just a story people make up to the explain stock price changes ‘stocks reached a resistance level due to investor profit taking ...’. That stuff is just BS the financial press makes up to sell papers or get clicks.

Lol, yeah. Some days there is a major piece of news that affects prices, but most days there is nothing. I laugh when I hear those news reports -- what, did they do exit polling at the trading floor to figure out what moved the market that day?

 

[BWV]

Umm, there's algorithmic trading, along with high-frequency trading done by computers. I believe the fad of high-frequency trading is fading away with some significant losses incurred by such decision making.

You are aware that the vast majority of high frequency trading is done for market making, i.e. providing liquidity to other investors?

Because speculative trading is alive and well. Just to take the last couple of days on the US stock market as an example, uncertainty and volatility have led to significant losses on the stock market. All, of which is due to well, in my humble opinion to human/market psychology.

speculative is an adjective without meaning, if you interpret it as 'high risk / high return investments with a positive expected value' then speculation is not irrational. People get paid in the stock market for bearing systematic economic risk, sometimes it does not go well - that is the nature of risk. Why should a decline in stock prices be proof of irrationality or anything else?

I believe the last couple of days on the stock market just demonstrates this fact. Please correct me if wrong, as that's entirely possible.

Another story is that equity markets are pricing in a slowing US and global economy and placing a higher probability of a recession in the near future based on recent information than they were three months ago.

I'm not sure what's the "greatest contributor to volatility".

the standard stock pricing model is dividend / (discount rate - growth rate of dividends) - play around with it - changes in the denominator cause greater valuation swings than changes in the numerator. A body of finance literature has documented this since at least this paper:

https://www.nber.org/papers/w3157

Well, I believe that the majority of the market is occupied by people, who have differing psychologies. Those psychologies seem to contribute to stuff like speculative trading, shorts, bubbles, and market corrections.

the alternate explanation is that the psychologies cancel out, leaving you with a market price that is as good a reflection of some hypothetical true value as you will find. Again, speculative trading is not irrational, and neither are shorts or market corrections. Bubbles are always easy to identify post ante, but that is merely hindsight bias

 

[Q-1]

That's a self-contradiction.

Sorry, I haven't yet realized what is self-contradictory in that post. Please elaborate.

 

[russ_watters]

Sorry, I haven't yet realized what is self-contradictory in that post. Please elaborate.

You basically said irrational yields rational. No, irrational is irrational, even if it is predictable.

 

[Q-1]

You basically said irrational yields rational. No, irrational is irrational, even if it is predictable.

I think it's more like known unknowns, and unknown unknowns. Once we have knowledge about those very known unknowns, then we can work on them in terms of known knowns. Sorry to borrow from Rumsfeld here; but, he pretty much nailed it.

 

[phinds]

I think it's more like known unknowns, and unknown unknowns. Once we have knowledge about those very known unknowns, then we can work on them in terms of known knowns. Sorry to borrow from Rumsfeld here; but, he pretty much nailed it.

(1) I have no idea how this tangent applies to this thread and (2) I think you completely missed Russ's point. Irrational is irrational. Period.

 

[Q-1]

(2) I think you completely missed Russ's point. Irrational is irrational. Period.

That could be true. But, my point was that there are aspects of our behaviour that are unknown to us. If those aspects become known to us, then we can develop countermeasures to their appearance or development. This is basically how therapy works for dysfunctions of behaviour or cognition in my humble opinion.

 

[BWV]

Human economic decision making has been studied and debated extensively:

Behavioral economics
From Wikipedia, the free encyclopedia
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the economic decisionsof individuals and institutions and how those decisions vary from those implied by classical theory.[1]

Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory.[2][3] The study of behavioral economics includes how marketdecisions are made and the mechanisms that drive public choice. The three prevalent themes in behavioral economics are:[4]

• Heuristics: Humans make 95% of their decisions using mental shortcuts or rules of thumb.
• Framing: The collection of anecdotes and stereotypes that make up the mental filters individuals rely on to understand and respond to events.
• Market inefficiencies: These include mis-pricing and non-rational decision making.

In 2002, psychologist Daniel Kahneman was awarded the Nobel Memorial Prize in Economic Sciences "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".[5]In 2013, economist Robert J. Shiller received the Nobel Memorial Prize in Economic Sciences "for his empirical analysis of asset prices." (within the field of behavioral finance)[6] In 2017, economist Richard Thaler was awarded the Nobel Memorial Prize in Economic Sciences for "his contributions to behavioral economics and his pioneering work in establishing that people are predictably irrational in ways that defy economic theory."[7][8]

 

[Q-1]

Behavioral economics is primarily concerned with the bounds of rationality of economic agents.

What if those bounds we're loosened by knowledge of those bounds and what exceeds them? Hence my topic.

 

[fresh_42]

I laugh when I hear those news reports -- what, did they do exit polling at the trading floor to figure out what moved the market that day?

Seems you weren't a friend of chartists either.

To me they top those news interpreters by lengths: sideward movement? What should that be? M versus W behavior. That's my source of laughter.