Behavioral Finance

-1Behavioral Finance

Behavioral Finance and Technical Analysis as the Solution to Fundamental Analysis and the Efficient Market Hypothesis

from the preface to the 1852 edition of Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay “In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons ofexcitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first. We see one nation suddenly seized, from its highest to its lowestmembers, with a fierce desire of military glory; another as suddenly becoming crazed upon a religious scruple; and neither of them recovering its senses until it has shed rivers of blood and sowed a harvest of groans and tears, to be reaped by its posterity.... ... Money again has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and riskedalmost their existence upon the turn of a piece of paper.

-2Behavioral Finance

United-ICAP

Summary - Top Ten Main Points 1. The financial markets are not rational and the dynamics of the market are not the efficient processing of new information into price adjustments. The markets are pre-rational, emotional, and with regard to the flow of information - highly inefficient. 2. The financialmarkets are the play and display of the full range of the qualities and vagaries of human nature. Any theory that attempts to describe the financial markets without placing human nature and collective human behavior as the center piece of the theory is doomed to failure. 3. The engine that drives price trends and price trend reversals in the finaicial markets are not investors making rationaladjustments to the price based on new information. The engine is the dynamics of herding behavior. 4. Herding behavior is always the expression of the survival instinct, whether that behavior is observed in insects, birds, or human beings. This phenomena of herding behavior has been hard wired into our nervous system by millions of years of survival pressure. 5. There is always an emotional componentto survival, whether it is the fight or flight response in a life or death situation or the struggle to survive and thrive as an investor or trader in the financial markets. 6. This emotional content of the markets grows in intensity and significance the longer a trend persists. This finding is unequivocal and is found in all markets. 7. Fundamental analysis presumes the rational translation ofchanges in supply and demand into price trends. Fundamental analysis has no way to measure the emotional content of the market or to compensate for an emotional bias. 8. It is not simply that fundamental analysis cannot account for the role that emotions play in the markets. The very process of fundamental analysis is corrupted by the same emotional content of the market that drives the pricetrends. 9. The problem is not simply the emotion of optimism in an up trend and pessimism in a down trend. Every single emotion and quirk and vagary in human nature is expressed in and magnified by the financial markets. 10. Technical analysis cannot be corrupted as easily as fundamental analysis. For example, a hammer bottom with bullish RSI divergence cannot possibly be viewed as bearish. Also,technical analysis can quantify the emotional content of the market. Based on this and the findings of behavioral finance, the inescapable conclusion is that for anyone serious about trading or investing, technical analysis is a necessity not a luxury.

The market recommendations contained in this letter represent the opinions of the author. Such opinions are subject to change without notice....