May 01, 2005
Behavioural Finance and the Emotional Impact of Charts in Trading
Mihaela Popa Chraif
Master DAFI-ASE (financial management and capital markets)
University of Bucharest, Psychology student
"The economist may attempt to ignore psychology, but it is sheer impossibility for him to ignore the human nature….. If the economist borrows his conception from psychologist, his constructive work may have some chance of remaining purely economic in character. But it he does not, he will not thereby avoid psychology. Rather, he will force himself to make his own, and it will be bad psychology."
John Maurice Clark
"Economics and modern psychology, Journal of Political Economy, 1918"
Abstract
To make progress we need to better portray behavior in the usual domains of finance theory and to incorporate new domains upon which finance has been silent. People appear to make probability judgments using similarity or what psychologists call the "representative heuristic", they evaluate the probability of an uncertain event by the degree that it matches a well known stereotype. Chap.1 provides promising new vision in finance and stocks, incorporates the methods used in the behavioral disciplines and decision sciences with the ones from Standard Finance, so that decision makers and their judgments can be studied from individual, group, organizational, and market perspectives. Behavioral and Experimental Finance the latest domains developed in finance field have the mission to foster a better understanding of those elements of human psychology, both cognitive (mental) and affective (emotional) that influence the decision making process. Chap 2 underlines the emotional power of the candlestick chart versus bar-chart and how easy people can visualize the evolution of the daily quotations without knowing advance market technical instruments. Also contain a comparing study using BET-index evolution using bar chart and candlestick chart.
CAP.1 INTRODUCTION TO BEHAVIORAL FINANCE
A new field known as "behavioral finance " has evolved attempting to better understand and explain how emotions and cognitive errors influence investors and the decision-making process. Many researchers believe that the study of psychology and other social sciences (economics, finance, insurance) can bring considerable light on the efficiency of financial markets as well as explain many stock market anomalies, market bubbles, and crashes. As an example, some believe that the out performance of value investing results from investor's irrational overconfidence (people tend to believe more in their own ideas then in others ideas, opinions in funds, investments) in exciting growth companies and from the fact that investors generate pleasure and pride from owning growth stocks. It is known that many finance researchers believe that the human flaws are consistent, predictable, and can be exploited for profit. People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down . It's human nature to choose a certain income fast coming despite a valuable one but in a long period of time .
People are overconfident in their own abilities, and investors and analysts are particularly overconfident in areas where they have some knowledge. However, increasing levels of confidence frequently shows no correlation with greater success because the greater success doesn't come from overconfidence! There is no luck! It is financial analysis of the markets, the statements, the stocks, funds and behavioral analysis of the investors in their rush, greed, loss aversion for fast profit. For instance, studies show that men consistently overestimate their own abilities in many areas including athletic skills, abilities as a leader, and ability to get along with others. Money managers, advisors, and investors are consistently overconfident in their ability to outperform the market; however, most fail to do so. People often see other people's decisions as the result of disposition but they see their own choices as rational. Investors frequently trade on information they believe to be superior and relevant, when in fact it is not and is fully discounted by the market.. On one side of each speculative trade is a participant (an investor) who believes he or she has superior information and on the other side is another participant (investor) who believes his/her information is superior. Both sides believe in gaining, no one in loosing. Unfortunately one of them has to loose!
Many researchers theorize that the tendency to gamble and assume unnecessary risks is a basic human trait. Ego and entertainment appear to be some of the motivations for people's tendency to speculate. People also tend to remember successes, but not their failures, thereby unjustifiably increasing their confidence in gaining fast with no financial basement. Sales professionals typically attempt to capitalize on the human nature behavior (gain more in a short period of time) by offering an inferior option simply to make the primary option appear more attractive. There are basic portfolio concepts, that investors must take in consideration when they make decisions: a portfolio of assets is considered to be efficient either if no other portfolio offers higher expected return with the same or lower risk, or lower risk with the same or higher expected return; the efficient frontier represents that set of portfolios which has the maximum rate of return for every given level of risk, or the minimum risk for every level of return; the standard deviation of a portfolio is a function not only of the standard deviation of the individual investments, but also of the covariance between returns for all the pairs of assets in the portfolio; the required rate of return for a risky asset has a plus risk premium for the individual asset. These concepts are theoretical and must be taken in consideration in decision of investment.
Behavioral finance doesn't complete the standard evaluation of the market –technical indicators, sensitivities to factor risks. In modern finance there is a synergic fusion between the behavior of the investors in funds, stocks, assets and the portfolio theory, capital assets pricing models. There are mathematical rules calculating the portfolio risk and the Modern Portfolio Theory (Markowitz) revealing the importance of the risk and efficiency in a portfolio of assets. This theory underline the follows: for an efficient portfolio (on the efficient frontier) the relationship between each stock expected return and its marginal contribution to the portfolio's risk is a straight-line; the standard deviation of a portfolio is a function of the standard deviations of the individual investments and of covariance between the rates of return for all the pairs of assets in the portfolio; the proper way to measure the risk of an individual asset is to assess its impact on the volatility of the entire portfolio of investments.
The dynamics of the investment process, culture, and the relationship between investors and their advisors can also significantly impact the decision-making process and resulting investment performance. The investors tend to pay more attention to the recently financial experiences despite the further ones. Also, they believe that their own decisions are perfect rational versus the others investors decisions. In financial investment process psychographics is used describing psychological characteristics of people and the particularly relevant to each individual investor's strategy and risk tolerance. An investor background and past experiences can play a significant role in the investment decision. For instance, women tend to be more risk averse than men and passive investors have typically become wealthy without much risk while active investors have typically become wealthy by earning it themselves.
Behavioral finance is considered one of the most controversial branches in the New Finance area and is gaining wider attention from financial economic community both academically and professionally. Its approach and building blocks have brought the underlying assumptions of Modern Finance theory and evidence into question. Although in its beginning stage, behavioral finance has been explored by many reputable financial economists who conducted extensive research and employed non-economic paradigms from its sister social science disciplines such as individual behavior and decision-making under uncertainty from psychology, group dynamics and decisions from sociology, and collective decision-making from political science. Their attempts have yielded practical and fruitful insights about many puzzles and anomalous phenomena in both the financial markets and the corporate settings, which are congruent with the analytical framework of positive theory suggested by Friedman (1953).
Behavioral and Experimental Finance have the mission to explain in a better way those elements of human psychology, both cognitive (mental) and affective (emotional) that influence the decision making process. The origins of behavioral finance have a strong theoretical foundation in the fields of experimental and cognitive psychology, sociology , and economics. Analyzing the financial market efficiency, "homo economicus " decides according his expected return and the marginal contribution to the portfolio risk, based on non-biased predictions. So, what you see depends on what you are looking for!
This article provides promising new vision in finance and stocks incorporates the methods used in the behavioral disciplines and decision sciences with the ones from Standard Finance. Also it hopes to evidence better the decision-making process and relate it with other disciplines by submitting how various cognitive processes and emotional factors may contribute to optimal decision making in finance and related fields with an interdisciplinary perspective including: financial psychology, behavioral accounting, behavioral law, organizational behavior, economic psychology, psychological economics, behavioral economics, and behavioral marketing.
Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocations of resources. The fields are primarily concerned with the rationality, or lack theory of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory adapting the cognitive and affective theories in decisional process of investment.
Behavioral analyses are mostly concerned with the effects of market decisions, but also those of public chose, another source of economic decisions with some similar biases. During the classical period, economics had a close link with psychology. For example, Adam Smith-the father of economics wrote The Theory of Moral Sentiments describing psychological principles of individual behavior. Economists began to distance themselves from psychology during the development of neo-classical economics as they sought to reshape the discipline as a natural science, with explanations of economic behavior deducted from assumptions about the nature of economic agents. The concept of ''homo economicus'' was developed and the psychology of this entity was fundamentally rational. Nevertheless, psychological explanations continued to inform the analysis of many important figures in the development of neo-classical economics such as Vilfredo Pareto, Irving Fischer and John M. Keynes. At the outset behavioral economics and finance theories were developed almost exclusively from experimental observations and survey responses , though in more recent times real world data has taken a more prominent position. Experiments simulating market situations such as stock market trading and auctions are seen as particularly useful as they can be used to isolate the effect of a particular bias upon behavior; observed market behavior can typically be explained in a number of ways, carefully designed experiments can help narrow the range of plausible explanations. Experiments are designed to be incentive compatible, with binding transactions involving real money the norm.
There are the main themes in behavioral finance and economics (Shefrin, 2002):
- Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analyses.
- Framing: The way a problem or decision is presented to the decision maker will affect their action.
- Market inefficiencies: Attempts to explain observed market outcomes which are contrary to rational expectations and market efficiency. These include non-rational decision making, and return anomalies.
Mental Accounts
What is a mental account?
When you go to a bank for opening a saving account you have just an amount of money in your pocket. The account in the bank has a virtual correspondent in your mind with the same amount. Back home, later you calculate the interest just using the virtual account opened in your mind, the real one is in the bank with all your money!
People usually operate with many types of mental accounts. In finance and accounting, the analysts of a company has opened mental accounts as many used in the balance sheet and in the income statement of the company. The investors have also different mental accounts depending of what they want to do: investing in mutual funds, financial funds, future options, bunds and so on.
When a stock is added to the portfolio, a new mental account is opened, having a reference point of the purchase price per share. Investors have separate emotional experiences toward each of their choices using virtual accounts. Each asset has "paper" (unrealized) losses or gains from its reference point, framing the portfolio in a manner, which overshadows its bottom line. Under mental accounting, investors live a personal "story" concerning their history with each an every investment asset in their portfolio, not unlike having a personal human relationship with each asset because they cannot taught the assets-they are imaginary! In practice, mental accounting infers that investors make small decisions sequentially one after another. The importance of this occurs during selling behavior, which requires the closing of an account.
As with personal relationship, those asset relationships with "unfinished business" or "personal baggage" are complicated, making termination difficult. Investors are reluctant to accept and realize individual stock losses because the very act of doing so proves that they chose wrongly initially. Underlying this dissonance, an investor likely comes to the conclusion that if he or she can "get even" then he or she can exit the stock without suffering loss. The initial impulse is to avoid the loss (loss aversion) and the investor's purpose is to "get even" or "break even". (Daniel Kahneman, 2002).
Investors prefer to "hope against hope" that the stock will recover, and allow them to feel better about their prior decision, reducing dissonance . This "hope-strategy" is not rational, having nothing to do with the reality of the stock's price in the marketplace. It is a mental shortcut, psychologically comforting to the investor, deeply personal, and not based on financial studies of the market.
From the perspective of the marketplace, the personal, emotional experience of the investor has brought more destruction upon investment portfolios than anything else because many of these virtual investment assets-mental accounts continue to plunge sickeningly to deeper losses.
The combination of theoretical and empirical work might allow us to see the relevance of the basic psychological theories to many financial phenomena. The research could help us to understand such things as the high volume of trade in some financial markets and its relation to economic circumstances, the tendency of markets to go through periods of high volatility or apparent speculative bubbles, and why issuance of equity by firms goes through alternatively hot and cold periods. The theory could help us to understand the failure of many individuals to save adequately for their retirement, and underinsuring for some of their biggest risks. About the firms and companies we could understand why some of them insist on paying dividends despite tax disincentives and others pay no dividends, why investors tend not to diversify effectively, and why investors have a "home bias," investing in their home country.
Research in behavioral finance has important applications , it comes providing the synergy between the theory (economic and financial models, concepts) and the non-bias individual investment of an ordinary investor who wants do gain fast and as much as possible by choice and expectation. So, it can help guide portfolio allocation decisions, by helping us to understand the kinds of errors that investors tend to make in managing their portfolios, and how to locate profit opportunities for investment managers.
CAP.2 Bar chart versus candle stick –"the sentiment and the emotion of the candlestick" (part one)
Me, you, my neighbor, our friends are ordinary people. We don't have knowledge about technical market instruments, statistics and portfolio risks, moving averages, high performing strategies but we want to invest in stocks! We love making money over the night just buying or selling shares! So, we see the ascending trend of the assets of the company X in financial magazine and we believe investing in it for a final goal: to gain more money. Continuing in a way the relevant importance of the behavior on the stock markets , we could see how strong is the impact of the stocks evolution (represented by daily evolutions charts) and index-prices in our decision of buying and selling stocks, shares, options and so on.
In the two images below it is illustrated the difference between the bar chart and the candlestick chart-for interpreting the day-to-day sentiment . The candlestick chart is more relevant and has a stronger emotional impact, determining the investor to buy or to sell than the bar chart about you have to have some more technically information before to decide what to do.
A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates the highest price a security traded at during the day, and the bottom represents the lowest price. The closing price is displayed on the right side of the bar, and the opening price is shown on the left side of the bar. A single bar like the one below represents one day of trading.(10)
Bar chart day quotation Candlestick chart the same day quotation (14)
The following is a list of some individual candlestick terms. It is important to realize that many formations occur within the context of prior candlesticks. What follows is merely a definition of terms, not formations.(13)
• White Candlestick -- when the close is higher than the open
• The Black Candlestick -- when the close is lower than the open.
• The Shaven Head -- a candlestick with no upper shadow
• The Shaven Bottom -- a candlestick with no lower shadow
The emotional impact of the candlestick bar chart is stronger than the bar-chart; people can visualize the evolution of the daily quotations without knowing advance market technical instruments and having high financial studies for being able to invest their own savings. It's easy! When the candlesticks are black (on white background) or red the price trend is going down ; when they are white-grey (on white background) or green the price trend is going up ! The green (or white) body of the candle transmits an optimistic mood of the market, the black and red reveals a pessimistic scenario.
Candlestick reversal patterns must be viewed within the context of prior activity to be effective. In fact , identical candlesticks may have different meanings depending on where they occur within the context of prior trends and formations.(it will be enlarged in the next article to underline the importance of the emotion and the cognition about the candlestick formations on the quotation trend).In the two charts below i am showing almost the same daily charts ( December in both charts can be compared as suggestibility) of BET –INDEX from Romanian Stock Exchange to illustrate the difference between the bar chart and the candlestick chart . In both charts you can see the overall trend of the stock price; however, you can see how much easier looking at the change in body color of the candlestick chart is for interpreting the daily sentiment.
bar chart
candle stick chart
In the chart above, you see the 'long black body' -it is white appearing on black background. The long black line represents a bearish period (a falling price trend) in the marketplace. During the trading session, the price of the stock was up and down in a wide range and it opened near the high and closed near the low of the day.
By representing a bullish period (a rising price trend), the 'long white body' –(the white is actually gray because of the black background) is the exact opposite of the long black line . Prices were all over the map during the day, but the stock opened near the low of the day and closed near the high . So, prices not only reflect intrinsic facts, they also represent human emotion and the mood of the moment. However, on a moment to moment, human emotions…fear, greed, panic, hysteria, also dramatically affect prices. Markets may move based upon people's explanations, not necessarily facts; so finally the prices reflect both facts and emotions . We could not forget the strong impact of the elections, natural calamities, and spreading rumors about the bankruptcy of the companies once profitable!
The candlestick techniques we use today originated in the style of technical charting used by the Japanese for over 100 years before the West developed the bar and point-and-figure analysis systems. In the 1700s a Japanese man named Homma, a trader in the future market discovered that, although there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of the traders. He understood that when emotions played into the equation a vast difference between the value and the price of rice occurred. This difference between the value and the price is as applicable to stocks today as it was to rice in Japan centuries ago. The principles established by Homma are the basis for the candlestick chart analysis , which is used to measure market emotions towards a stock . A big difference between the bar charts and the Japanese candlestick line is the relationship between opening and closing prices . It is placed more emphasis on the progression of today's closing price from yesterday's close. (13)
These charts can be applied to many markets; however, they are most often used in the equity and commodity markets. The Heikin-Ashi technique is extremely useful for making candlestick charts more readable-trends can be locate easily, and buying opportunities can be spotted at a glance. The charts are constructed in the same manner as a normal candlestick chart, with the exception of the modified bar formulas. There are many technical ways to estimate the profit and loss in investment but beside we choose the easiest for understanding we must contact a financial analyst who act with integrity, competence and ethical manner for maximum efficiency.
References
• Fabrozzi, F. ,'Theory and practice of Investment Management' , Wiley New York , 2002
• Friedman, Milton and William Allen, 'Midnight Economist: Choices, Prices, and Public Policy', Playboy Press,1981
• Markowitz, Harry, ' Portfolio selection' , published in ' The journal of finance', 1952
• Kahneman, D. & Tversky, A. 'Prospect Theory: An Analysis of Decision under Risk,' Econometrica , XVLII (1979), 263–291
• Tversky, Amos and Kahneman, Daniel, 'Choice, Value, and Frames' , Cambridge University Press UK , 2000
• Tversky, Amos and Kahnemann, Daniel, 'Judgment under Uncertainty: heuristics and biases', Cambridge University Press, 1982
• Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford University Press
• Shleifer, Andrei (1999) Inefficient Markets: An Introduction to Behavioral Finance , Oxford University Press
• Stancu Ion,' Finance and portfolio management', editura economica, 2003
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• http://www.investorsdepot.com/goldenrules.htm
• Dreamstime.com images