Tuesday, October 20, 2009

Inertia and Opportunity in Markets: A View From Behavioral Finance

Interesting research suggests that investors are "inertial" when presented with a situation in which their shares of Company A are bought out by Company B. Instead of analyzing Company B as a distinct holding and possibly divesting those shares, investors tend to retain the shares of Company B with little analysis or forward planning.

Such inertia takes place when traders and investors anchor themselves to old ways of viewing situations and thus discount new data that suggest that their situations have changed. For instance, investors may initially underweight earnings surprise data, only to later overweight it as repeated earnings "surprises" are integrated into a revised view of the company.

In trading, we see inertia when a position is obviously going against a trader, but the trader does not exit the position until an obvious stop out level is hit (such as a clear support or resistance area or an even-numbered price level). At that point, underreaction leads to overreaction, as the trader "pukes" the position at the worst possible time.

Inertia yields a kind of market inefficiency derived from human nature. If we can identify where traders are leaning the wrong way but not yet acting on data contrary to their positions, we can squeeze opportunity from markets. The key to such a strategy is to identify occasions in which markets are telling traders they are wrong, but traders are not yet acting on that information.