Saturday, January 12, 2008

A Theory of Psychological Relativism

All perception is perception of difference.

I'll start with three premises:

1) All perception occurs within a context and is shaped by that context - The same meal tastes different to a starving man and to a sated one. A 50 degree (F.) noon temperature feels cold in summer, warm in winter. An automobile moving 55 miles an hour down a freeway seems to go slow; down a side street, it would feel like a race car. When I was a student, producing a 40 page paper was an ordeal; now it is a routine process. There is no perception independent of context: what we experience is inextricably wound with our histories and our environments.

2) We respond psychologically to difference: to situations that are contextual outliers - Events that are normal for our particular context are experienced as routine and fail to elicit strong emotional responses. When we experience something unique--something outside our normal context--we are most likely to respond with strong emotion: surprise, fear, curiosity, and excitement. A song or joke heard the first time is unique and may generate a strong reaction. On the 20th hearing, it no longer elicits emotion.

3) Markets elicit the strongest psychological responses--and display the greatest inefficiencies--when they depart from contextual norms - It isn't the absolute magnitude of price rise or fall or the absolute magnitude of bullishness or bearishness that impacts markets, but the degree to which current market behavior departs from recent norms. Markets that behave differently from their recent pasts elicit psychological responses from traders that bias their appraisals of value and skew decision making.

A good theory is one that, not only explains existing observations, but suggests new ones. In upcoming posts, I will explore some implications of psychological relativism in markets.


Relative Price

Relative Range

Relative Dollar Volume Flow