Limit Orders, on the Crumbling Edge of Behavioral Finance

Crumbling Limits

Although behavioral psychology has helped explain some of the odder effects around investment there remain many sceptics. The reason for this isn’t hard to find, because if you start out assuming that peculiar features of investment markets are caused by rampant misbehavior then you’re quite likely to find evidence to support that assumption.

Some of this is down to irrational behavior, no doubt, but perhaps not in the way that the academics first thought. So, for instance, consider the use of the humble limit order. Used unwisely – which is to say, nearly always – it doesn’t just lose investors money but ruins the researchers’ results into the bargain. Just watch those behavioral biases crumble away.

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One Price To Rule Them All

Models. Behaving. Badly: Why Confusing Illusion With Reality Can Lead to Disaster, On Wall Street, And In Life by Emanuel Derman

"In physics there may one day be a Theory of Everything; in finance and the social sciences, you have to work hard to have a usable Theory of Anything."

The idea that the theories of physics are qualitatively different from the models of finance has been one of the longest running themes on the Psy-Fi Blog – all the way back to this post on Newton’s Financial Crisis. Now the polymathic ex-theoretical physicist, ex-quant for Goldman Sachs, Emanuel Derman, has written a book on this very subject; and very unusual it is too.

Being Derman this is no ordinary description of the problem, but one that roams widely across the realms of science, philosophy, autobiography and finance. At the heart of the discussion is a key idea, that the Law of One Price is a basis for most securities valuations and works not because it’s a deep law of nature but because it’s a simple rule of thumb that can’t be misused in any meaningful way.

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The Wisdom of Internet Crowds

Crowds in the Clouds

We’ve already seen signs that internet data can be used for various sorts of prediction. Using Google trend data allows nowcasting of employment trends and the spread of disease (see Nowcasting with Google), Twitter may predict stockmarket movements (Twits, Butter and the Super Bowl Effect) and social media predicts investor sentiment (Noise, Sentiment and StockTwits). Reports suggest that there are already fund managers out there exploiting these ideas.

The question remains whether these sources of information are really reliable or whether we’re seeing data mining biases. The more data you have the more probable it is that you can find a correlation between any two variables, proving little other than having a lot of computing power makes work for idle processors. Not all data is equal, though, and some results suggest that the wisdom or crowds is alive and well in the internet clouds.

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How Sneaky Governments Steal Your Money

Debt Do-Do

Many nations in the developed world are in deep do-do with their debt levels. On one hand they need growth to earn their way out of their problems, while on the other they’re being forced into anti-growth austerity measures by markets, concerned about their spiralling interest obligations. It’s a grim position for those of us brought up to expect an unrelentingly rosy economic outlook.

This isn’t a new situation, though. We’ve been here many, many times before and governments have, by design and evolutionary accident, developed many, many ways of dealing with these problems. The cunning thing is that many of these involve stealthily thieving from their own citizens, but done so surreptitiously that, if we’re not careful, we won’t even notice it.

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The 160 Billion Dollar Bezzle

Bezzled by Their Blind Spot

It’s sort of common knowledge that private investors generally lose by over-trading; invariably individuals think this only applies to other people and not to themselves, but you're just Bamboozled by Your Bias Blind Spot. The question remains, however, just how much do private investors lose by this behaviorally challenged frenzy of trading?

Figures are hard to come by, but one rule of thumb estimate suggests that US investors gave up $160 billion dollars in 2010 through this hyperactivity. Which is a nice boost for the denizens of the underpaid and underappreciated securities industry, struggling to keep their superyachts afloat.

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Noise, Sentiment and StockTwits

Don't be Sentimental

As we saw in Idiot Noise Traders it very much looks like there are people out there trading on the random oscillations in markets – which themselves make predicting the markets extremely difficult, particularly at times when irrational noise traders are dominating proceedings by synchronising their behavior. If this hypothesis is true then increasing ease of access to real-time internet trading data and opinions ought to be making markets less efficient, rather than more.

This implies that a contrarian investor should be looking to bet against the noise traders, rather than against the performance of stocks, so it’s of significant interest to figure out what the current sentiment of day traders is. Some recent research on the behavior of investors using the microblogging site StockTwits offers some interesting clues to whether this might work.

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Idiot Noise Traders

Who's Noisy Now?

In 1985 Fischer Black published a paper entitled “Noise”.  In this he argued that much of the irrationality in financial markets could be explained by people trading without information: essentially using various spurious signals to decide when to buy or sell. In fact there’s an argument that without such people markets couldn’t work at all. The downside of this is that it’s difficult to separate the noise from the information.

Black predicted that there would be people who spend their lives trading on noise – so-called “noise traders”; people that Paul Krugman calls "idiots". Unfortunately these idiots generate so much noise that it’s very hard to determine the real information, which would suggest that if we're not careful, at root, we’re all idiots.

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