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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