Nobel Winners explain Behavioral Economics – Part 2

Last week, I detailed a few ways how understanding the behavioral economic concept of prospect theory can help you profit from the currency market. In part 2, I will discuss how this year’s Nobel Prize laureate for economics, Richard Thaler, has developed theories that can also improve your trading strategy. Thaler was specifically recognized for detailing the biases and cognitive shortcuts people use for absorbing and processing information.

Richard Thaler is a principal of Fuller and Thaler Asset Management, a very successful small-cap focused asset management house that reliably beats 90% of its competition. One of its stated strategies is to obtain a yield by trading the over-reactions and under-reactions to events by market participants. Does this strategy fall in line with the efficient market hypothesis, that because ‘the prices are right’ and there is ‘no free lunch,’ it’s virtually impossible to gain a consistent profit by trading the markets over time? Thaler’s answer is a hesitant ‘yes, but...’

Thaler seems to have reservations regarding the idea that the market price is the right price and secondly, that there is some ‘predictive power’ in signals where prices have deviated too far from historical levels and ‘the further they diverge, the more seriously they should be taken’. Rather, he adds the caveat that one should not expect to get rich by timing the market because it’s very hard to predict when mispriced stocks will converge with fundamental levels. This important behavioral financial observation applies to stocks, but is it relevant to currencies as well? This author would also like to respond with a ‘Yes, but…’ Indeed the behavior of currency pairs also appears to retrace from over-bought or over-sold levels over time. In Forex prices also bounce around in either direction following the release of important economic data. The market undergoes a process of incorporating new information into the price which inevitably leads to a ‘correct’ fundamental level. The reason why Thaler’s observation does not apply is due to the highly liquid and highly volatile nature of currency markets. As there are substantially more market participants in forex than stocks (particularly small-cap), pricing gaps are closed far more rapidly while the mispricing itself is harder to discover.

So, would Thaler say it’s possible to lock in profits trading currencies by accurately estimating over bought and over sold levels? Perhaps he might suggest two ways a trader can do this: arbitrage and range trading. Due to restrictions in trade placement speed and implementation costs such as spreads, arbitrage is not feasible realistically. This leaves range trading as a possible strategy. Range trading opportunities are produced by the market continuously building into the price new information (price response as volatility). Therefore traders should seriously consider learning and applying technical indicators that detect overbought-oversold market conditions within an upward, downward or sideways trending price range (oscillators CCI, RSI, support/resistance, etc).

Incorporating Thaler’s work can improve currency trading strategies by developing better trader discipline. His contribution towards understanding ‘confirmation bias,’ where people will often seek information that supports and affirms their pre-existing beliefs and “hindsight bias,” where people tend to believe they had predicted an event before it had happened, can help people be aware of potential trading shortfalls.

Traders need to be mindful that when building a case to open or close a position, arguments for and against need to be correctly weighed and judged with minimal bias. Pros and cons also need to be impartially collected. For example, reading and giving overly prescient value to an extremely bearish blog that warns of the impending collapse of a financial system, is a very quick way to lose money especially when economic data tells the opposite story. Awareness of a tendency for hindsight bias can assign strategic credit where it is due. These anti-bias strategies prevent a trader from falling into the trap that one had accurately predicted the market when in reality a large part of trading profitably comes down to luck and adequately cutting losses. It’s a mindset of humility - the only proven tool of addressing overconfidence.

Part 3 of this series will further outline common cognitive biases that debilitate traders and how an awareness of them can improve trading strategies and discipline.