The "Grandfather" of Behavioural Economics

In late March, psychologist and economist, Daniel Kahneman, passed away at the age of 90. His work with Amos Tversky and others helped to establish the field of behavioural economics, including explaining cognitive biases and heuristics, and developing Prospect Theory. In 2002, Kahneman was awarded the Nobel Memorial Prize in Economics "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty". Kahneman also wrote best-selling books including Thinking, Fast and Slow.

Kahneman's insights in the world of trading highlight biases such as overconfidence, herding behaviour, and loss aversion. His work is highly relevant for trend following managers, whose quantitative systems seek to exploit market inefficiencies. In this article, we provide a brief taste of some of Kahneman's work and how trend following is consistent with his elucidation of human behaviour.

The Reflection Effect

One aspect of Kahneman & Tversky's seminal Prospect Theory is the Reflection Effect, which describes how people's appetite for risk changes when we think about the same decision focusing on gains or focusing on losses. Kahneman and Tversky demonstrated that people are risk averse in the domain of gains, and risk seeking in the domain of losses. For example:

• A positive "gamble": given the choice to take $900, or take a 90% chance to win $1,000 (mathematically the same outcomes), people will generally tend to take the $900. It can be explained through the lens of the psychological value of the certain outcome being worth more to people than the prospect of winning $1,000. That is, an extra $100 doesn't seem worth the risk of getting $0

• A negative "gamble": given the choice of losing $900, or take a 90% chance to lose $1,000 (mathematically the same outcomes), people will generally tend to take the chance. Here we see the inverse (or reflection) of the positive gamble - the psychological value of potentially losing nothing is worth more than the risk of losing $1,000 instead of the $900. That is, the additional $100 loss doesn't seem to outweigh the potential positive of losing $0

That is, people will tend to take a risk to avoid losses, and will avoid risks to lock in gains. They will even make different decisions based on how a problem is framed.

There are studies around breakeven effects which further show risk seeking in the domain of losses. Experiments were conducted where people were studied at horse tracks, and found that punters placed riskier bets (longer odds) towards the end of the day, when they were on average already making losses - that is, they tried to win back their losses to break even. We can see this effect in force when investors hold on to losing stock market trades, hoping they will go back up to break even, or even take on riskier trades to try to win back losses.

Trend following systems are designed to overcome the Reflection Effect. Where human psychology instinctively has us locking in gains, trend following systems let profits run. When human psychology tends to steer us to take bigger risks to avoid losses, trend following systems are designed to limit losses through consistent and unemotional stop loss levels.

Emotions vs Rationality in Markets

Although those of us who are schooled in the field of Finance are taught the Efficient Market Hypothesis - that asset prices reflect all available information, behavioural economics highlights the role of emotions in decision making. Cognitive biases such as overconfidence, herding, information bias and loss aversion may help to explain market bubbles / "irrational exuberance" as well as "over-reactions" contributing to market crashes.

For example, Kahneman and Tversky found that people will typically extrapolate broadly from narrow data sets, which they called the Law of Small Numbers. To illustrate this effect, consider:

• tossing a coin three times to find it lands on heads each time - one might extrapolate that it is more likely to land on heads in the future, but

• tossing a coin a very large number of times shows us that overall the odds are 50/50 of a heads or tails result.

We can see that this cognitive bias may result in flawed decision making, and irrational market behaviours.

Trend following systems are designed to attempt to exploit irrational market conditions, and to avoid cognitive biases through systematic approaches to trading. Our strategies at ECCM are tested over long term, deep and broad data sets to avoid information biases and enhance objectivity.

At our website and our YouTube channel you can view our video "Embracing Objectivity Through Systematic Trading", in which ECCM's founder and CIO, Adam Havryliv, and Strategy Ambassador, Richard Brennan, talk more about our approach to statistical analysis and how we seek to avoid cognitive biases. 

Conclusion

Daniel Kahneman and his colleagues developed highly influential and insightful studies which have helped to explain human behaviour and in turn market dynamics. We recognise his work and the impact he had on our understanding of financial markets.

At ECCM, our educational foundations are in finance and psychology. With extensive trading experience and long-term dedication to quantitative trading systems, we seek to provide our clients with our carefully developed approach to navigating the complexities and vagaries of markets.

Wholesale clients can find more information on ECCM and our flagship ECCM Systematic Trend Fund at our website and Australian Fund Monitors.