Jun

29

Predictably Irrational, by Ariely, (hat-tip to Riz Din for cite!) was a great read and has provided some deep insights into personal trading and many common everyday situations in the days after reading the book. It also provides a good basis for testable hypotheses of a quantitative nature in trading.

Behavioral economics is popular and most traders are familiar with Kahneman and Tversky's works. Some of the ideas were discussed in the Black Swan directly or indirectly. The idea is that people are not rational agents as posited by traditional economics, but rather are influenced by unexpected and rather random cues in their environment and lead them to make decisions which are not rational, and which the author asserts are predictable. We see this in other traders (but not us, of course) everyday. It is this element of predictability which he does not go into in detail and which give some ideas to the trader using quantitative methods to predict the path of prices and provide a laboratory of data. The author has documents many interest anecdotes with experiments conducted on subjects that seem to support his ideas. Presumably, but not documented, the underlying statistics of the experimental data lent support to his hypotheses.

Some of the random cues that influence people's decisions are:

  1. Relativity, where experiments show that choices tend to be made between relative values rather than absolute values. One example is where people tend to choose the middle of three choices, when on an absolute basis, the cheapest might have been the best value. We see this in the circumnocution of market prices. This effect is seen in dating where a girl with an ugly friend looks much better than she might standing alone. This might be seen in the comparison of two companies in the same sector.
  2. Anchoring is the tendency of agents to choose a price close to a price randomly presented to them earlier which has not rational connection with absolute value. Again we see this in market action with the tendency to revert to the opening prices.
  3. The issue of the illusion ownership which makes the agent tend to place an excessive premium on things he owns or is bidding on, even to his detriment. This makes it harder for people to get out of trades. This also might suck a trader in deeper than he wants to be having entered into an undesirable trade when it might just be better to wait.
  4. The ownership effect makes people tend to cling to trying to keep options open, even when its more advantageous to close the door and choose one alternative.

These effects occur every day in personal lives, and in the markets. The traders trick is to find those irrational behaviors that cause losses to other traders and exploit their predictability.

The observer effect might be seen in the market in the tendency of prices to revert to or near a prior observed price such as open or prior close.


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3 Comments so far

  1. Michael F. Martin on June 29, 2008 7:00 pm

    Although it has been very useful to economists and investors by introducing some important new research in psychology and neuroscience, some proponents of bounded rationality have fallen into the same trap that game theorists fell into a generation ago by equating rationality with symmetry in preferences.

    http://brokensymmetry.typepad.com/broken_symmetry/2008/06/thomas-schellin.html

    Some of bounded rationality theory could be explained by the broken symmetries of variations in time. Much of economic theory (at least at the level of government policy and private accounting) still depends on a static picture of supply and demand. We could improve the performance of many government and private institutions by redesigning our measurement and reporting rules with some microeconomic theory of growth in mind.

  2. Gary Rogan on June 30, 2008 12:35 am

    I seems odd that it’s still possible to take advantage of the behavioral economics discoveries, after so many books and articles on the subject. There is an almost stylized feel to the way these “discoveries” are presented by more and more authors, as if each one has just heard them from Tversky directly. How many times can one hear about “loss avoidance” and be strangely surprised by it? And how many times can “hanging on to the losers too long” be described as some mortal sin instead of a compulsive value investing strategy?

  3. Neuromarketing » Book Review: Predictably Irrational on July 7, 2008 8:36 am

    […] FT’s Books: “…each story remains separate and strangely non-enticing. Try Freakonomics or The Tipping Point for more excitement.” Daniel Wahl: “Speak for yourself, brother.” (Mr. Wahl believes himself to be rational.) Strategic Profits: “It’s simply a must-read for every marketer and business owner.” Jenny Doh: “It’s a fascinating book.” Funeral Words: “Chapter 1 alone, which shows the impact of packaging in the magazine business, is worth the price of the book.” Daily Speculations: “a great read… has provided some deep insights into personal trading and many common everyday situations.” […]

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