Tag Archives: Behavioral Finance

Last week I attended my first academic conference. It was held at UCLA and focused on the field of Behavioral Finance. This is the area of academic research which has been challenging the tenets of Efficient Market Theory. As such, it's a field of study that is highly applicable to the way most market participants I've met and talked with over the years think. I look at it as the study of traders, at least in certain sub-set areas.

One of those sub-sets of Behavioral Finance is the field of neurofinance, which attempts to see how our brains impact on how we trade and invest. During the conference there was a presentation by Dr. Paul Zak (Claremont Graduate University) outlining the findings of research he's done on learning and market bubbles.

Bubble experiments
For some time now, researchers have studied the development of market bubbles in laboratory experiments. The version used by Zak in his study is one where the participants are given the opportunity to trade an instrument which has a fairly easily calculable value based on its proscribed cash flows (think dividends or interest payments), one which declines steadily toward zero over the span of the experiment.

One would think in a situation like this that trading would be pretty straightforward, but that doesn't end up being the case. These experiments repeatedly feature the creation of significant bubbles in the price of the asset – meaning it trades well above its fundamental value.

Learning comes into play
It is worth noting, though, that as participants go through the experiment repeated times their behaviors change. The bubbles gradually reduce in size. The implication there is that as people learn they are less likely to act in a manner which drives the market price well above the baseline value of the asset.

Learning is important. Who'd have thunk it?

Bring on the drugs!
To take a closer look at the impact of learning on bubble formation, Zak and his fellow researchers divided the participants into three groups. One was given a drug which impaired learning. A second group received a caffeine pill on the idea that might actually improve learning. The final group was given a placebo. As it turns out, caffeine didn't end up having any real impact above that seen from the placebo.

The impairment drug, however, did act as advertised. Traders on the drug took longer to see their bubble formation reduced, reflecting slower learning. Part of that was from reduced trading activity. They just simply didn't trade as often as their un-drugged peers. Less trading equals less learning.

The conclusions
Dr. Zak presented three conclusions from his research (and that which went before).

1)    Traders who learn market history are less prone to inflating bubbles.

2)    Market/trading learning must be salient, meaning there must be a risk/reward factor (participants in these studies always have monetary rewards at stake as the results are different when there is no real risk/reward element). In other words, to learn you need to trade real money, not paper money.

3)    Infrequently traded markets are more subject to bubbles (real estate being the obvious example).

So basically you would do well to invest considerable time and effort in your trading and markets education and make sure it involves real money, not demo trading. Also, be aware of the markets which are more prone to mispricing (smaller, less actively traded ones) as they may either present opportunities or represent unnecessary risks.