Author: shyam

A technical analyst knows the price of everything and the value of nothing.

The Rational Expectations Hypothesis is based on three interlinked assumptions:

1. Individuals do not behave irrationally
2. Individuals learn from their mistakes
3. Individuals arrive at their decisions independently of one another

However, REH fails in the real world. Natural forces encourage people to herd together as groups. Groups behave as single organisms that respond in predictable ways to new information, have their own emotional cycles and follow a definable path of growth and decay. This is the rationale for technical analysis.

Technical analysis assumes that prices reflect the entirety of investors’ expectations of the fundamentals (both economic and company specific). Financial markets will always be trying to anticipate the future and hence market prices precede changes in fundamental conditions. And most importantly, each price movement is mathematically related to preceding price movements.

Read the review of the first few chapters here.

Evolution is the unfolding of order and complexity in the process of learning.

Aren’t investors supposed to behave rationally at all times? What is the reason behind seemingly intelligent and rational individuals caving in to heard-instinct? The simple truth is that membership of a crowd causes people to behave differently from the way that they would in isolation.

In fact, herd-instinct is hardwired into our brains. Our brain stem (the innermost part of the brain) that is primarily concerned with instinctive behaviour, developed over 250 million years ago, compared to our neo-cortex (which allows us to be aware of the thought process itself and to anticipate the future/recreate the past) that developed only during the last 50 million years or so. The operation of the neo-cortex is all too easily suppressed by the emergence of a crowd mentality. As the crowd comes into being, the brain stem and the limbic system hold sway.

Membership of a crowd involves the abrogation of personal responsibility to some degree. A crowd tends to behave in a non-rational way and forces its members to do the same. For most people, some form of crowd pressure provides a major motivating force in their social, economic and political activities.

So in essence, a crowd is a self-organized entity defined by a common purpose. Once a crowd is formed, it will react to new pieces of information from the environment. Feedback loops are created and leaders emerge. The feedback loops create stable fluctuations (limit cycles) in the relationship between the crowd and the environment. These limit cycles are subjected to shocks and the crowd readjusts to deal with unfamiliar events. Understanding limit cycles and the readjustment process is key to understanding and predicting the the overall behaviour of the crowd.

We have discussed various styles of investing, including one based on technical analysis. Technical analysis flies in the face of the efficient-market hypothesis. EMH says that the prices of assets already reflect all past publicly available information. However, by using technical analysis, one is trying to use past data to project future prices, something that wouldn’t be possible under EMH.

Even if EMH were to be true for individuals, people behave differently when they are in groups. Sometimes a person will be relatively individualistic and at other times the same person will be relatively willing to conform to expectations imposed by others. Individual behaviour is not easily predictable, but group behaviour is.

Over the next few posts, I will be reviewing chapters, in sequence, of the book: The Psychology of Technical Analysis. Hope you will join me in the journey towards discovering the secrets of technical analysis!