Behavioural Psychology And Your TradingSimon Coulter

Head of Development and Risk Management MahiFX

About MahiFXMahiFX is an online retail trading platform offering clients exceptionally competitive spreads and great customisable charting functionality.

Simon Coulter, is the Head of Development and Risk Management at MahiFX and will be discussing the key areas of human behaviour which can have major implications on your trading decisions. In the webinar, he will discuss some practical examples of how to recognise and address these issues.

Key Discussion Areas Of The Webinar

• What is Behavioural Finance and why is it important to my trading/investing?

• Discussion on the Efficient Market Hypothesis/Behavioural Finance relationship

• Key areas of Behavioural Finance• Examining how knowledge of these (above) can

increase our awareness of why the markets behave how they do, and help us adapt our trading/investing

What Is Behavioural Finance?Behavioural Finance is the study of the effects that social, cognitive and emotional factors have on economic decisions and consequences those decisions may have on market pricing, returns and resource allocation

Behavioural Finance and Market EfficiencyDoes Behavioural Finance research cast doubt over prior assumptions on market efficiency?

Key Behavioural Heuristics And Biases

AnchoringCognitive bias which sees people rely too heavily on initial pieces of information when making decisions causing subsequent judgements to be anchored to the informationExamples include:1. Current prices used as anchor in determining

current fair values2. Investment bank analysts and economist

forecasts are often anchored around previous numbers and around other analyst consensus forecasts

3. Starting points of negotiations influence the negotiated outcome

4. Support and resistance levels can be traced to anchoring

How Does Anchoring Effect Our Trading Decisions?

Anchoring can have a severe impact on our ability to give an objective probability on the likely outcome of a trade or investment leading to poor decisions about the risk inherent in trades/investments

ConservativenessThe tendency for people to cling to a view, closely linked to anchoring, it can be caused by overconfidence. Main result of this is the under-reaction to new information

Some Key ConceptsConfirmation biasTendency to seek information, which conforms to our view, ignoring contradictory informationIllusion of validityTendency for people to think their views are more valid than they actually areCognitive dissonanceMental conflict caused when faced with contradictory evidence, tends to see us seek conforming evidenceAlternative historiesObserved outcome was just one of a number of possible outcomes given the complex participant decision making process at play

Conservativeness And Points To Consider With Our Trading

1. Be especially mindful of confirmation bias when back testing trading rules, address the problems that curve fitting presents

2. Seek out alternative viewpoints and information that run counter to yours

3. Avoid scanning the world of technical indicators to find ones that back up your view, sticking to a smaller sphere may be helpful in this regard

4. Try to increase your understanding of markets and the context within which events are developing

5. Seek out the opinion of the majority it likely provides valuable information on what not to do, and how not to be positioned

Representativeness

Bias which causes us to estimate the likelihood of something happening being based on how closely it resembles something else. It causes people to place too much weight on recent data. The heuristic helps us see patterns in data and saves on computation

Illusory CorrelationTerm that refers to our propensity to see patterns and correlation in random/uncorrelated events

Representativeness And Our Trading

1. Relying too heavily on recent data can cause us to extrapolate recent movements

2. Will assume future patterns will resemble past ones without having sufficient regard to context

3. Can cause traders/investors to over-react to repeated bouts of similar news, when combined with conservatism (which often causes under-reaction) we can see large moves in pricing as people extrapolate the new results and attach them to their new model

Price Bubbles/Busts And Positive Feedback Trading

Extreme cases where prices continue to climb then fall as noise traders chase the trend. Noise traders will react to past price changes rather than any particular news per se. Encourages extreme cases of positive feedback trading where buying/selling encourages further reactionary buying/selling

Trend chasing and price movements from stop loss orders are good examples

ReflexivityPrices influence fundamentals, new fundamentals change expectations, further influencing prices creating a self-reinforcing feedback loop

Representativeness/Feedback Loops And Our Trading

1. Prices do not rise forever, expect mean reversion2. Incorporate the effects of positive feedback and

noise trading into your decision process when positioning and considering trade levels

3. Be wary of price manipulation that attempts to create short-term feedback loops

4. Be extremely wary of crowd behaviour during price bubbles, recognise that stringent discipline is especially critical during these periods

Over-Optimism

Illusion of controlWhere people feel in control of a situation far more often than they actually are. People often fail to distinguish between chance events and those that require skillSelf-attribution biasThe tendency for people to attribute positive outcomes to their own skill and whilst attributing negative outcomes to bad luckRandom reinforcementThe tendency for people to attribute random outcomes to skill

Over-Optimism And Our Trading

1. Don’t trade before you have the skill and necessary understanding to trade

2. Develop a trading plan, critically evaluate performance against the plan, have another trader review the plan

3. Don’t confuse randomness with positive expectancy

4. Keep a detailed record of trades and evaluate that performance against your plan. This will help address our tendency to have a selective memory for winning trades and reduce random reinforcement

Overconfidence

Closely related to over optimism. Refers to propensity for people to believe they will be right in their forecasts far more often then they actually areHindsight biasThe tendency for people after the fact to believe they had predicted the outcome beforehandSurvivorship BiasThe tendency for failed entities (companies) to be excluded from performance studies because they no longer are in existence. Causes results to be skewed higher in studies, as only those which are successful enough to survive are included in the study

Overconfidence: Points To Consider In Our Trading

1. Seek disconfirming evidence2. Never be 100% sure about anything3. Events in the market follow an improbable script4. Markets normally always go against the majority

to the benefit of the minority5. Be aware of testimonials from marketers of trade

package solutions, which prey on this bias6. Keep a record of trades and analyse them

carefully

Equity Curve AnalysisTracks the performance of the system by analysing the equity curve to ascertain periods when our system is in and out of sync with the market• Allows us to track multiple systems with varying

degrees of correlation allowing us to increase/decrease capital commitment to them as they move in and out of sync with the market

• Enables traders to have more simplistic systems that are more flexible, less likely to be the result of having curve fitted while testing historical expectancy and will have a wider definition of favourable market conditions

NonstationarityKnowledge derived from previous statistics is less reliable due to changing participants

Availability Bias, Framing And Prospect Theory

Availability BiasPeople assess the frequency or probability of an event by the ease with which they can think of examplesFramingPeoples behavioural outcomes and attitudes are influenced by how given piece(s) of information are framedProspect TheoryPeople are far less willing to gamble with profits than losses

Availability Bias, Framing And Prospect Theory (cont.)

Loss AversionPeople gamble with losses because we cannot bear to cope with losses so we will do anything to avoid themDisposition effectPeople are predisposed to holding losers and selling winnersStatus quo biasStrong psychological benefits brought about by taking no action and avoiding loss realization

Points To Think About With Our Trading

1. When entering a position ALWAYS put your stop loss in the system

2. Think about your Risk/Reward ratio, don’t be too aggressive with your ratio, have adequate stop loss buffers

3. Be clinical with loss realization, recognise its part of being in this business and not a failure per se. Confront any negative emotional responses to losses and develop positive behavioural strategies

4. It is far better to gamble with profits than losses, letting your profits run allows your returns to increase exponentially, pulling stops to break even when in a profitable position (where it makes sense technically), and partial profit realization are effective ways to do this

Summary

The field of behavioural finance whilst still subject to considerable debate offers valuable insight into the flaws in our decision making process and our desire for shortcuts. At the very least, knowledge of the ideas discussed today will help us as traders increase our awareness of these biases thereby introducing a more objective framework within which we trade.

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Questions?