Monday, February 25, 2008

Should You Really Trade What You See?

"Trade what you see" is a common mantra among short-term traders who formulate their trade ideas from charts. But do we process information from charts in accurate and non-biased ways?

An interesting set of studies reported in the 2003 Journal of Behavioral Finance suggest that perceptual biases in what we see can skew our trading and investment decisions.

Specifically, when investors see a chart that has a salient high point, they are more likely to want to buy that stock. When the chart depicts a salient low point, they are more apt to sell. In the words of the authors, "expectations about future prices assimilated to extreme past prices."

The authors found that, when a chart contained a highly noticeable high point, traders listed more favorable features of the stock; when the chart depicted a salient low, more negative aspects of the stock were emphasized. Their analyses suggest that charts affect investors by providing them with enhanced access to either positive or negative information about the stock. In other words, our processing of the chart creates a selective bias in retrieval, leading us to view shares in artificially positive or negative ways.

It isn't too far from the authors' finding to a broader psychological hypothesis that *any* highly salient feature of a trading situation may skew information retrieval, perception, and action. For instance, the salient information may be a recent large gain or loss; a dramatic market move; or a piece of news. Trading what we see might be dangerous for the same reason that it is dangerous to trade what we hear or what we feel.

When one facet of a situation becomes highly salient to us, we overweight it in our perception and information processing. Our ability to view the entire situation in perspective is compromised. What is most obvious in a chart--or in our minds--may not be an accurate reflection of underlying supply and demand in a marketplace.


Perceptual Distortions in the Market

Inside the Trader's Brain

Attribution and Bias in Trading