Trading and Behavioral Science
Stockscores Foundation for the week ending October 1, 2019
In this week's issue:
In This Week’s Issue:
- Upcoming Events – Free Webinars in October
- Stockscores Market Minutes Video – What is an Alpha Stock?
- Stockscores Trader Training – Trading and Behavioral Science
- Stockscores Feature Strategy – Do Nothing
Upcoming Events – Free Webinars in October
- Sat Oct 19 10:15am PT – 10 Essential Principles for Trading the Stock Market
- Tue Oct 22 6:00pm PT – How to Be a Profitable Stock Investor
- Thurs Oct 24 6pm PT – How to Be a Successful Day Trader
Click here to register
Stockscores Market Minutes – What is an Alpha Stock?
It is easier to make money trading if you are focused on trading Alpha stocks. This week, I explain what an Alpha stock is and how to find them. Then, my market analysis to understand if there is more of a market correction coming. I scan the market for some longer-term trading opportunities and then look at a day trade from Friday that showcases what an Alpha stock is.
Click here to watch this week’s Market Minutes
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Commentary of the Week – Trading and Behavioral Science
While we hear about how markets are traded by computers more and more, I believe that it is still people that move markets. The computers take little bit of profit along the way and may affect the short-term liquidity for stocks, but trends and substantial price moves are driven by human judgment.
This makes it important to understand how humans make those judgments. Traditional stock analysis assumes that we make rational decisions based on the information we have about the company. However, what one person considers to be a rational decision might be considered completely foolish by another. Many investors will make moves that are predictably irrational.
Behavioral economics and finance are fields which have still not hit the mainstream, but many of the theories of these disciplines are part of my approach to the market. Here are some areas of research by behavioral theorists that I find are applicable to what we do as trader and how they relate to some of my trading concepts:
Up trends start slowly, there are often pull backs early in the trend.
"A conservatism bias means that investors are too slow (too conservative) in updating their beliefs in response to recent evidence. This means that they might initially underreact to news about a firm, so that prices will fully reflect new information only gradually. Such a bias would give rise to momentum in stock market returns." - Bodie, Kane and Marcus (2005)
People tend to make judgements by what has happened recently rather than what happens most of the time.
"Gambler's fallacy stems from two sorts of confusion. First, people have very poor intuition about the behavior of random events. With gambler's fallacy, they expect reversals to occur more frequently than actually happens. The second source of confusion stems from the reliance on representativeness." - Shefrin (2000)
For most people, profits in the stock market are short term loans.
"People are overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Does overconfidence occur in investment decision making? Security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence." - Nofsinger (2001)
How we judge information is largely dependent on our mood.
"The discovery that the weather in New York City has a long history of significant correlation with major stock indexes supports the view that investor psychology influences asset prices." - Saunders (1993)
People often wait to buy a stock until it has been going up for a while, in the end, paying too much.
"People prefer the familiar to the unfamiliar"
You are not smarter than the stock market.
"The illusion of control is the tendency for human beings to believe they can control or at least influence outcomes which they clearly cannot."
For every trade, there is a buyer and a seller. The buyer thinks the stock is going up, the seller thinks the stock is going down. One of them is wrong.
"Psychologists Hillel Einhorn and Robin Hogarth (1978) have studied the general issue of why people persist in beliefs that are invalid, that is, why they succumb to the illusion of validity. Einhorn and Hogarth suggest that people do so because they are prone to search for confirming evidence, not disconfirming evidence."
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I ran a lot of Market Scan this morning in search of some promising charts but found nothing. Sometimes, it is best to sit on your hands (and your cash).