All you want to know but never asked about the stocks and options markets.

martes, 22 de septiembre de 2015

The herd effect in trading

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How many times have we seen a cafe crowded with people waiting to catch table when, next door, was another cafe virtually empty and obviously with free tables? It is possible that the service in the first place is better than the second, but it is also certain that a very basic factor is acting on the crowd: the herd effect.

We have a natural tendency to do what others do. By default, we tend to repeat behaviors of others. But, however ridiculous it may seem this behavior, this trend is an evolutionary residue, an advantage that we have developed over time and has a very clear purpose: survival of the group. If all members of a group act the same way, it becomes stronger and more efficient. The group thus provides protection to the individual, but at the same time strongly conditions their thinking, feeling and acting.

Let's see it clearly in the following real experiment: two strings of different lengths were laid on the ground. Different subjects were then asked to point out the longest string. Some of them were "control" subjects, ie, the scientists had previously agreed with them to point out as the longest string the one that actually was the shorter string. Others were "experimental" subjets, ie, they knew nothing about the test subjects. When all subjects were gathered, were asked to decide which string among all was the longest and the group of experimental subjects began to point out what was the actual longest string. At the insistence of the control subjects, they began to express doubts until finally denied the undeniable and ended up claiming that the longer string was actually the shorter string.

Such is the influence of the group over the individual, that can affect the sound judgment and perception. The herd effect is a tendency tightly etched in our genes, of which it is very difficult to escape.

Likewise the herd effect on the financial markets work: we tend to buy when everyone buys and sell when everyone sells, seeing in many cases tarnished our ability to perform a realistic analysis of the situation.

This is what causes that, in a particular news or data, markets sometimes react sharply and disproportionately, aimless fit the actual situation. This happens precisely because all the agents decide to buy or sell at a time. Flooded by panic or euphoria, the agents act in unison and in the same direction: the purchase or sale. It is very difficult not to enter the market when everything goes up or leave it when everything going down. It is very difficult, again, not to do what everyone else is doing.

Gain in the stock market, as in any other transaction, is in the end to buy low and sell high, and sometimes the herd effect is preventing us from carrying out this task, pushing precisely to the opposite: buy high and sell cheap, suffering innecesary losses in our trades.

Stay calm, avoiding decisions motivated by fear and euphoria (beware of the alarmism of some media) and an analysis as objective and realistic as possible of the data we have can help us to escape the herd effect and find real investment opportunities, or a comfortable cafeteria with care and quality menu. 

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