Posts tagged ‘extrapolation bias’

The Triangular Harmony

triangular_harmony

A simple triangle can integrate all market theories. Can we spot it?

While writing ‘Theory of Moral Sentiments’ in 1776, Adam Smith would never have thought that after 2 centuries people will find it oxymoronic to see morals and sentiment in the same phrase. Now, sentiment creates the popular news, lack of morals are ascribed to capitalists and what’s left of the father’s work are fragmented theories.

Today markets and prices are believed to be efficient, inefficient, random and/or ordered. All efficiency experts won’t subscribe to the mathematical order and some believers of inefficiency will call randomness preposterous. If this was not enough, we even have a few thinkers defining a new model of finance different from economics.

Unlike the coherent attempt to find a universal scientific string theory, there is no attempt to look for an integrated market model. A few behaviorologists are trashing efficiency theorists, who in turn call behavioral finance as nothing more than ‘anomalies dredging’. Meanwhile the other two viz. random and order experts tune their trumpets. It’s a cacophony out there, exacerbating the confusion as the historical crisis unfolds.

There is one thing common in all these market specializations. Implicitly or explicitly they all look at patterns. Behaviorologists are trying to model human emotion. Fundamentalists attempt to model market information. Random experts wait for the recurring odd event. And order driven experts call the market model a pattern or fractal.

Behaviorologists raise some questions like, “Can the human mind count?” There are of course limitations to the human minds computing ability, the very reason we cannot be called pure rational beings. This is the same reason why even if there was complete order till infinity, we would find it muddled with randomness. What if the whole debate regarding market type is because even specialists, like rest of us all suffer from biases? What if markets were efficient, inefficient, ordered and random on the same scale but on a different time? What if order or chaos was a factor of time?

If we assume this to be true, we start answering most of the discrepancies between the various theories. Behaviorologists say humans suffer from an extrapolation bias, suggesting that we can’t see the future and we judge the past and present to estimate the future. This is why when we are on the efficient side of the market mountain, we just see efficiency. Simply putting it, we just see positivity when we are on a rising trend. When markets are inefficient or say falling, we just look down and are unable to see the bottom or impending order. This extrapolation bias also explains why humans underreact or overreact. When we cannot see the top of the market mountain, we cannot judge how far the high is, this is why we underreact. And when we are on the declining face, we just can’t seem to place the low and we tend to overreact.
Behaviorologists call it momentum and reversal dichotomy as they don’t see the market mountain. We can explain every other behavioral human error of loss aversion, disposition, ambiguity, validity, representativeness, winner’s curse, gambler’s fallacy, heuristics, framing, risk return distortion, over and under confidence, hope and anxiety, optimism and pessimism, if we continue to look at the market as a two dimensional triangular pattern, a face up and down, a low- high – low, a cycle. One can see how the errors start getting polarized along the positive and negative slope, order being the positive and flip side of the negative uncertain chaos.

The triangle also explains why behaviorologists see the fundamentalist’s conservatism in earning predictions as the reason positive surprises tend to be followed by further positive surprises. The unanticipated surprise is the hallmark of overconfidence, a positive slope characteristic of the cycle. The three phased glitter and stock selections linked to excess volume, recent news and extreme price reaction is another up cycle character. The unending debate of the Fama and French three factor model, one side talking about efficiency and other side challenging it are also on different slopes of the same triangular cycle. Psychologists say fundamentalists select stocks like bonds, “good stocks are stocks of good companies”. The reason they follow thumb rules and extrapolation is because the ongoing polarity of the up cycles, makes them comfortable and complacent. This is why high degree of sentiment interest is followed by subsequent low returns. The turn down catches a majority by surprise. This is why psychologists compare option traders to farmers, taking more risk with cash crops after planting sustenance crops and hedging the downside. It’s our way to take more risk, inefficient risk when we feel hedged. This is the reason we always misprice options.

The same triangle can explain why buybacks happen more at market lows and cause under reaction compared to overreaction, meaning though buy backs end up performing better, they get less attention from investors, investors underreact. Possession and dispossession of dividend also leads to over reaction and under reaction. When investors feel they own a dividend, they tend to over react and take more risk and vice versa. The behavioral criticism that humans are naive trend watchers is because humans don’t understand cyclicality. It is this same lack of understanding of cyclicality why past performance fails.

The holistic pattern can also explain why prices will always keep oscillating between efficiency and inefficiency? Why riskless pair trading done on price will never be riskless? Why long-short funds playing on price are not hedged like LTCM thought and can fail? Why there will always be psychologists writing ‘trading is hazardous to your health’? Why existence of markets is linked with our inability to see the triangle? Why flipping coins can explain randomness, order, efficiency and inefficiency? Why there will always be a conflict and challenge to earn profits in economics? Why capitalism will always be driven by crisis? Why correlations are cyclical like performance? Why behavioral strategies have more tests to pass? Why saving for tomorrow is a hindsight bias? Why we save when we should invest, and why we invest when we should save? Why Mandelbort and Taleb work together, though one is the father of mathematical order and the other claims to be the philosopher of randomness? Why ordered fractals are very close to chaotic randomness? Why the Nobel Prize winning prospect theory is about ownership and disposition that blinds humans against cyclicality? Why Prechter-Parker’s Financial-Economic dichotomy in social behavior dynamics is not the new model of finance, but the other face of the mountain? Why demand sensitivity to price can rise and fall? Why we can make money in markets through physics, mathematics, history, psychology and so on? Why access to information and belief in it is triangular?

The two faced cycle links everything. We are not trying to simplify 200 years of market knowledge. It was always like this, simple. Psychologists are as biased as everybody else, even if they claim to be otherwise. Time contrarianism is not for everyone, as the preordained harmony kills all the beautiful stories.

ORPHEUS RESEARCH AT REUTERS – UNITED KINGDOM

ORPHEUS RESEARCH AT REUTERS – USA