Profitable ETF Trading Strategies - Appreciating Behavioral Finance

What does psychology tell us about market returns? Are we programmed by biology to fail in the stock market? How do professional traders deal with the limitations of human cognition?

Profitable ETF Trading Strategies - Appreciating Behavioral Finance
By [http://ezinearticles.com/?expert=Ken_Long]Ken Long

We know that people pride themselves on their rationality and analytical skills. This is very evident in traders who invest a lot of psychological energy into their systems and personal discipline. It is also very clear that psychology is extraordinarily evident in financial decisions. Time and again, psychological pressures will over-rule rational analysis and the herd will behave in predictable, reliable, sub-optimal ways when markets reach extreme conditions.

There is no purely rational explanation for this behavior unless you study human cognition and then recognize that human decision making is a blend of both emotional intelligence and rationality. Most evidence from the literature favors emotional intelligence as the dominant force, particularly in times of stress, when the brain is flooded with hormones that trigger the fight or flight behaviors which have been so successful in biological evolutionary terms for millions of years. The development of conscious rationality is a relatively recent phenomenon, and in moments of stress cannot compete with our unconscious and subconscious thought processes. No matter how much we may want to believe that we are rational creatures with pure free will, biology tells us otherwise.

The Nobel prize winning work of Kahneman and Tversky in behavioral finance is a direct look into the workings of the human mind in this respect. Their investigations have spawned a whole host of scholarly inquiry that reinforces these ideas of the importance of the often counter-productive role of normal instinct and snap decision-making in financial markets.

The habits and processes of mind that have proven to be so successful in the physical, biological world do not migrate effectively to financial markets where flights to safety at moments of extreme pain characterize price action at market bottoms. When all the people who can be driven from their positions and there is no one left to sell, then all the remaining market players are able to more or less calmly gather up great bargains.

It is a combination of art and science to know when these moments of extreme overreaction have occurred. The market is littered with the corpses of bottom-pickers who staked their capital on the confidence they had in their ability to rationally pick the bottom, unlike the other pilgrims who panicked at that price level. Mistaken confidence in our own ability to be rational accounts for these many false starts.

What can a trader do who wants to participate in the opportunity represented at or near market bottoms but doesn't want to repeat the mistakes of other would be bottom pickers and panicked sellers? It is a real challenge, and anyone who offers a fail-safe, high reliability should be looked at skeptically. They should be asked to explain how their method of selection and timing accounts for the demonstrated fallibility of rationality in moments of stress. Why is their method different than those of the failed traders who right up until the moment of catastrophe were supremely confident?

This is the challenge of Long Term Capital Management, whose Nobel prize winners were undone by their belief in the power of their own special brand of rationality and nearly brought down the world financial markets.

Can it be that success in the markets is NOT a function of pure rationality alone? That as long as markets are driven by emotional responses to moments of extraordinary stress that the emotional qualities of human psychology will produce statistically unlikely occurrences on a regular basis? I think so, and I will always operate on that basis until I see compelling evidence to the contrary.

It turns out that survival in the market begins with a heightened sense of danger that begins to account for the possibility of extreme adverse market moves well before the selling is fully manifested. Does this mean that there are times when you have to forego the apparently easy money that comes from following irrationally exuberant megatrends?

I believe so, in the same way that the wise second mouse must forego the easy cheese sitting out there in plain sight. The first mouse often gets the easy cheese until that swift moment of final total consciousness when he discovers that the easy cheese was not so easy after all. Unfortunately the first mouse doesn't get to reflect for very long on his new found knowledge.

I want to be the second mouse, and design systems and rule sets that operate on that basis and philosophy.

Examine the source and basis for your confidence in your own abilities or in the abilities of your trusted custodians. How does their approach account for the possibility of overconfidence?

Good hunting!

Ken Long, Chief of Research, Tortoise Capital Management

finance: http://www.tortoisecapital.com

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