The twin perils of emotion and logic

Fund Strategy - 21 Nov 2011 | By Vanessa Drucker

Investors are their own worst enemies. As perpetual victims of their egos, they make self-serving excuses, and sacrifice discipline to protect their self esteem.

Behavioural economists identify many of these all-too-human biases that distort how investors interpret evidence. For instance, investors resist selling their losing positions, because they hate to feel foolish. A “framing effect” encourages them to cling emotionally to a past purchase price, anchored to the high point at which they first took a position.

However, technical analysis can help us withstand self-destructive financial impulses and correct our mistakes. Let us return to the irresistible urge to get out even. Markets often trade in a range between support and resistance levels, just as global equities have done over the past few months. “You could make a killing this year in short-term trades by following technicals,” observes Mark Tepper, a financial planner at Strategic Wealth Partners in Seven Hills, Ohio.

Why do prices tend to gravitate to support and resistance areas? Think of teams of bulls and bears on either side. After a resistance level is breached on the way up, few bears remain, and those remaining are suffering losses. Psychology shifts. Some may even take their lumps, reverse course, and jump on board with the bulls. The resistance ledge becomes a battle in collective memory, a Gettysburg of pains and gains to test and confirm a directional trend.

Round numbers may exert a psychological impact at these Waterloos. Buyers and sellers place more orders as a stock approaches a round number, making it harder to move beyond it. “Look how the Dow has been flirting with 12,000,” Tepper points out. Or remember all the hoopla and celebratory baseball caps when the average first crossed the 10,000 threshold in 1999. Note how Apple stock has struggled to break $400. (Techside continues below)

Investors must still recognise when it is time to get out. Once again, a vulnerable ego may refuse to let you recognise a mistake, or sheer greed may keep you invested too long. “Don’t fall in love with a stock you bought and are following,” warns Hersh Shefrin, a professor of finance at Santa Clara University. “Managers may do a good job of choosing stocks, but they don’t let go in time to pursue another good opportunity.” If they heeded flashing technical signs, they might find the sell decision easier to execute.

On the other hand, a technical approach can also prompt investors to focus too much on short horizons and to overtrade. Shefrin is collaborating with Arvid Hoffman of Maastricht University on a new study. They are using a data set of 5,500 Dutch investors to explore how a technical versus a fundamental approach has driven performance. They note that technical practitioners turn over stocks more frequently than fundamental counterparts, resulting in a poorer net performance.

Yet Shefrin hastens to differentiate between individual investors and professional traders. The former in their data set, who “tinker,” rely only on basic technical tools: support/resistance levels, moving averages (which smooth trend lines) and filters (arbitrary percentage moves for trading signals). Experienced traders, says Shefrin, may be more successful at “snap moves” in fast moving markets.

Herding is another behavioural phenomenon that lends itself to technical tactics. As momentum gathers pace, investors extrapolate too much from past performance and trends persist too long, exceeding fundamental values before they change direction and revert to a mean.

Guy Ortmann, a senior technical analyst at HFP Capital Markets in New York, uses several indicators that synchronise neatly to identify market extremes. In particular, he follows two oscillators, which are charts that show when a market is overbought or oversold, and ripe for a countermove.

The Rydex ratio is derived from a fund family that specialises in index and sector funds, in many cases employing leverage. The sentiment indicator divides the total assets of Rydex bearish fund money plus money market funds, by the total assets in Rydex bullish funds. “It’s an excellent psychology gauge that displays how real investors are investing their money, rather than a mere reflection of their opinions,” Ortmann explains.

The oscillator runs from about negative 40 to positive 40, with a neutral zone between zero and 20. If the ratio is 40% or higher, that nosebleed territory means leveraged players are aggressively putting money into long funds. In early July, the ratio measured 35%; it had plummeted to negative 20 by early October. On October 4, the S&P 500 registered 1,076, with investors “leveraged up to the eyeballs,” says Ortmann. The pessimists were crushed when the market turned and soared 200 points.

Ortmann also peruses the Gambill insider ratio, which calculates corporate insider sentiment. Developed by Scott Gambill, it measures insider buying to selling in each of the Russell 3000 stocks, and tends to spike at or near market bottoms. While the Rydex ratio sizes up the crowd, Gambill’s measurement surveys informed investors. “Who knows more than insiders?” Ortmann asks.

Beyond signaling sentiment extremes, these oscillators also act as a shock absorber, revealing the underlying condition of equity markets for handling whatever type of news hits the tape. So when an indicator is overbought, it suggests that good news will have less impact and vice versa. When it is oversold, a whiff of good news makes more impression.

Behavioural finance and technical analysis share many common underpinnings. Psychology teaches that humans yearn for pattern recognition and seek to impose meaningful shapes and stories. While financial theorists labour to quantify probability distributions, the naked eye can sometimes spot simple patterns better than any computer. In a visual instant, we are all wired to register and analyse troves of information. A glance at a technical chart can sometimes trump powerful hardware, and a canny ability to register technical price formations may beat armies of statisticians.

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