Because the economic agents acting with the marketplace are largely human, the constructs used to model investor behavior are necessarily bounded by the limits of our psychological theories. Inadequate psychology means inadequate economic models. (Bear with me for a moment.)
Back to the 50’s
Classical economics assumes that the financial markets are mostly rational, albeit subject to short-term random fluctuations due to news events. This accords with the classical view of the “normal” human personality developed in the 1950s by Ellis and others. It is a Father Knows Best economics based on simple equations and fractions reduced to the least common denominator. It’s a simple world where misunderstandings have a happy ending every 30 minutes.
As the discipline of psychology has matured, however, it has become better at perceiving the true complexity of human motivation and decision making. Parallel with that, economic models of market behavior have also become more complex and non-linear.
Wake Up, Neo
Whereas the naive 20th century investor was seduced by the dot com bubble, the 21st century investor is now aware of the non-linear (irrational) behavior of the market and it’s tendency toward extremes and subsequent mean reversion. It’s like Neo seeing through the robotic Agents in The Matrix, a film released in the last year of the old millennium.
Although the Nasdaq 100 is once again flirting with 1999 levels, volume is a fraction of what it was back then because the 21st century investor can perceive irrationality more objectively. The moth is more wary of the flame.
Trend Following 101
This is progress, but our keen perception of market dynamics means we are more likely to make incorrect gut-level assumptions and predictions about market behavior.
The most common expression of this error is the tendency to think in a contrarian manner and call tops in stocks and markets once we perceive irrational exuberance. Ironically, we can become irrational about irrationality.
Despite our new awareness, Homo Sapiens are still slow to correct emotionally driven behavior in areas where we are psychologically invested, such as personal finance. This applies to bulls and bears alike. To correct the tendency to be a serial top picker, do your best to remember that the trend is always our friend… and enjoy the irrational ride.
= = =
Learn more about Dr. Kenneth Reid’s day trading coaching services here.
