I have posted some educational content which you will find useful for your trading career. This content is valuable to both experienced traders as well as to traders that are just starting out.
Behavioral finance (BF) and human biases
Traditional finance (TF) focuses on how individuals should behave. It assumes people are rational, risk averse, and selfish utility maximizers who act in their own self-interests without regard to social values-unless such social values directly increase their own personal utility. Such individuals will act as rational economic men. A direct consequence of traditional finance is EMH where prices reflect all available, relevant information.
Behavioral finance (BF) focuses on describing how individuals do actually behave and make decisions. It draws on concepts of traditional finance, psychology, and neuroeconomics. Neuroeconomics has been used to study decision making under uncertainty, drawing on studies of brain chemistry to understand how decision making utilizes both rational and emotional areas of the brain. Market participants do not act as rational economic man and therefore they are affected by some biases which affect their decision making process.
Biases are distinguished in
- Cognitive errors: are a consequence of information processing mistakes, defective reasoning, memory errors and not proper understanding statistical analysis techniques
- Emotional errors: are linked to emotions, sentiment and intuition.
The cognitive errors that are more relevant are:
- Conservatism bias: occurs when market participants rationally form an initial view but then fail to change that view as new information becomes available.
- Confirmation bias: occurs when market participants look for new information or distort new information to support an existing view.
- Representativeness bias: can take several forms. In each case a too simple decision rule takes the place of more detailed analysis.
- Illusion of control bias: exists when market participants think they can control or affect outcomes when they cannot. Illusion of control bias occurs when traders believe that they can truly “forecast the future”, failing to realise that trading is a probability game in which their ability to affect the outcome of trades is virtually zero.
- Hindsight bias: occurs when investors tend to remember their correct views and forget the errors. They also overestimate what could have been known in the past.
- Anchoring: changes are evaluated in relation to the initial view and therefore the changes are inadequate.
- Mental accounting bias: occurs when investors treat money differently depending on how it categorizes it. For example a client might mentally treat wages differently from a bonus when determining saving and investment goals. He might be more inclined to invest the bonuses in more risky investments because he perceives this extra-wealth as “free-money”.
- Framing bias: occurs when decisions are affected by the way in which the question is asked. For example, the answer to a question may be different depending on the words are used.
- Availability bias: occurs when investors give too much weight to readily available information.
- Loss aversion: differing from the traditional finance perspective which assumes individuals are risk-averse, behavioural finance maintains that individuals are loss-averse it means that more pain from a loss than pleasure from an equal gain.
To avoid the pain of loss and to accept they have made a mistake, investment holders will tend to hold on to losers too long but may sell winners too quickly.
- Trade too much by selling for small gains which raises transaction costs and lowers returns.
- Holding assets that have deteriorated in quality and lost value, with no intention to sell.
- After a loss investors are inclined to take excessive risk in the hope of recovering.
- Treating money that is made on a trade differently than other funds and taking excess risk with such money.
- Myopic loss aversion: short term risk of stocks is given too much importance thus making a too high equity risk premiums in the market.
- Overconfidence bias occurs when market participants overestimate their own intuitive ability or reasoning. Overconfidence causes investors to hold too concentrate positions.
- Self-control bias: occurs when individuals are not disciplined and so they tend to focus too much on immediate gratification than long-term goals.
- Status quo bias: investors exhibit status quo bias when comfort with the existing situation leads to an unwillingness to make changes.
- Endowment bias: occurs when an asset is felt to be more valuable simply because it is already owned.
- Regret-aversion bias: occurs when market participants do nothing out because they are afraid that their action could be wrong.
Fundamental vs Technical Analysis
Below you can find a video which explains the basics of Technical and Fundamental analysis.