Markets

How to read the mind of a mad market without going insane yourself

how-to-read-the-mind-of-a-mad-market-without-going-insane-yourself

When the stock market goes bipolar and oscillates wildly, what’s the impact on your emotional state?

Computerised trading algorithms might be increasingly preferred over human beings because side-lining sentiment improves results. Computers “don’t get emotional about the stock”, to quote a famous line from the movie Wall Street.

The same obviously cannot be said for people. In the hit TV series Billions, an in-house hedge fund psychiatrist is deployed to handle trading floor mood swings.

Read more: Does the sell-off signal the start of a bear market?

But it’s not just panic, fear and greed in play during volatile periods. Now new research poses the question: is there also a natural human tendency to infer that the market has a mind of its own?

Personifying financial risks is what gamblers do when they curse the roulette wheel, convinced it’s started scheming against them. This is referred to by psychologists as “intentionality” or the “intentional stance”, and appears a universal tendency.

Because of the way our brain is wired, to wrestle with other people and their intentions, we see intentionality everywhere, even projecting intentions onto inanimate objects. There is a famous scene in Fawlty Towers where John Cleese is desperately rushing for a deadline, but frustratingly, his ancient car breaks down. Furiously, he remonstrates with the stubbornly stationary vehicle, pleading with it to start, eventually smacking it for disobedience.

Are investors guilty of this error of intention, with negative consequences for profits?

Traders may be making decisions partly on an assumption that the entire market has a single mind of its own. So how effective can they be? How good are you at mind-reading? Can you figure out what people are thinking without having to directly ask them? This skill is referred to by psychologists as “mentalising”, and the maths whizzes who dominate finance are often poor at it.

A new study entitled Perception of Intentionality in Investor Attitudes Towards Financial Risks, from the Brain, Mind and Markets Laboratory at the University of Melbourne and the Computation and Neural Systems Department at the California Institute of Technology, used the latest brain scanning technology to explore investors’ brains as they make trading decisions.

Researchers found no link between performance on the financial tasks they set investors and their scores on mathematics and logic tests. Instead, it was superior psychological mind-reading skills that correlated significantly with better performance in these trading experiments.

The regions of the human brain which tend to be particularly active in situations where subjects are doing more mind-reading were found to become particularly active during market movements such as “bubbles” and “crashes”.

In this study, it is argued that it is part of our basic nature to view the market movements as if generated by a mindful agent with its own intentions and desires.

This “intentional stance” can at times help investors – it led to better investment decisions in the case of markets with “insiders”. But at other times the intentional stance is a mistake. It misleads investors in particular market situations, for example when deciding to “ride” a financial bubble.

This intentional stance explains some classic investor errors, for example, the famous “gambler’s fallacy”. Just because a certain number has not come up for an extraordinarily long time on the roulette wheel, does not mean its time has now come and it’s worth betting on.

The gambler’s fallacy leads people to assume runs must end sooner than they might. If you think that the market behaves like a person and has intentionality, as an investor you will tend to assume it will reverse its direction of travel sooner than you would believe if you understood the market was not a single person with its own mind.

Another recent study (Mental capabilities, trading styles, and asset market bubbles: Theory and experiment) used laboratory replication of trading scenarios to demonstrate that to correctly grasp the fundamental value of an asset, a trader needs analytical skills, but to accurately judge market sentiments, she also needs to read minds.

The authors argue that analytical capability alone does not generate substantial trading gains, because poor mind-reading produces misinterpretations of price deviations from the fundamental.

But strong mind-reading ability alone, these economists argue, produces even more serious mistakes, because these “mentalising” traders will detect and follow an upward price trend, but miss the optimal exit point, since they do not sufficiently account for the fundamental.

What this new research suggests is that Billionaires contains a major plot flaw involving the shrink. If the hedge fund psychiatrist were properly assisting the traders, she would be helping them accurately read the minds of the markets, and they’d be making so much profit they wouldn’t need therapy at all.

Read more: The psychology behind bitcoin: How to spot a bubble

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