PSYCHOLOGY AND TRADING

PSYCHOLOGY AND TRADING
A critical factor in decision making concerns expected outcomes. It turns
out that people tend to be overconfident of the quality of their decisionmaking
abilities. A closely related phenomenon is that people are unduly
optimistic. For instance, when asked to estimate sample quantities in lab
experiments, people assumed they would guess correctly about 98% of the

time, but they actually guessed accurately only about 60% of the time.6
Events they thought virtually certain actually occurred only 80% of the
time; events thought virtually impossible actually happened 20% of time.7
Over 90% of people participating in surveys thought they were above
average in driving abilities, sense of humor, and ability to get along with
others.8 People systematically underestimate the time it will take them to
accomplish tasks.9 They read more into the data than is there. A classic
example is the sports fan's belief in a player's hot hand even when there is
no evidence of it.10 People tend to persevere in their beliefs. They avoid
contradictory evidence, and when confronted with it, tend to overdiscount
it.11 When people form estimates starting with an arbitrarily determined
initial value, that value often becomes a critical point of reference for no
CHAPTER 4 Electronic Markets
good reason. The estimation process can simply become psychologically
anchored in an arbitrary reference point.12
The economics profession is skeptical that evidence garnered from
psychological experimentation is applicable to financial markets.
Economists argue that people learn from mistakes and adapt their behavior
to avoid similar mistakes in the future. Further, professional traders are
likely to be systematically different from the rest of the population; in any
event competitive forces are likely to ensure the survival of successful
traders and winnow out the unsuccessful ones. Expert traders at investment
banking firms will make fewer errors than most, and trading firms
can structure incentives to minimize mistakes.
Barberis and Thaler, scourges of the EMH, concede that the biases that
people bring to financial decision making can be "unlearned." But, they say,
bias cannot be eliminated altogether. Moreover, there is evidence that
expertise can be more of a hindrance than a help: It turns out that financial
market professionals sometimes exhibit more overconfidence than laymen.
Finally, while getting incentive structures right may reduce bias in decision
making, a literature review by Camerer and Hogarth could find no replicated
study that eliminated bias just by changing incentives.13
If psychological foibles can lead to irrational trading decisions that
overwhelm arbitrage, is electronic trading likely to be an exacerbating or
mitigating factor? On the one hand, it would seem that electronic trading
ought to reduce the incidence and duration of mispricing. Expanding the
scope, depth, and breadth of the market (as electronic trading does) brings
more information, more agents, and more perspective to events, which
ought to reduce the impact of outliers. On the other hand, electronic networks
may exacerbate herding effects, facilitate information cascades,
and increase the danger of financial gridlock. The question centers on the
role played by "noise traders."