In Financial Markets, Relying on the “Wisdom of Crowds” Can Be Very Risky

We all tend to do what everyone else does. This saves time and effort on many occasions, but it can cost you a lot of money in financial markets

We all tend to do what everyone else does, even when we can see that everyone else is wrong.  In financial markets, this can lead to bubbles and herd behaviour.  It is important to be aware of this tendency within our psychology, so you can at appropriate times avoid joining in the bubbles.  It is important to do this because you will lose a lot of money if you participate or, once in, fail to exit before everyone else does.

In this post, I will briefly outline the relevant psychology so you can both look for the effects in your own thinking and expect those same effects in other market participants.  This will improve your trading.  I discuss this bias and many others in a financial markets context in my new book (see link below).

Conformity Bias is also known in the literature as the Asch Effect, after the pioneer experimenter.  Asch obtained really surprising results, which will show you how strong this effect is.  He had a naive member of the public sit in a room in front of a blackboard with four other people.  The member of the public thought that the other four people were also naive members of the public, but in reality they were actors who were going to behave in a specific way suggested by Asch.

A line of a certain length was drawn on the left side blackboard.  Some other reference lines of different lengths were drawn on the right hand side.  One of them was clearly the same length as the reference line and all of the rest were clearly much shorter or much longer.  Asch then had the people say which of the test lines on the right was the same length as the reference line.

If the naive member of the public went last and heard all of the actors give a wrong answer, he tended to go along with them even though the answer was obviously and clearly wrong.  Amazingly, Asch found that most people gave an obviously wrong answer some of the time and also that some people gave wrong answers most of the time.

This is how strong Conformity Bias is: it works even when the answer is obvious.  Imagine how much more dangerous it is in financial markets where the answers are much less clear cut and much ambiguous and conflicting data must be weighed.

I think this is one factor behind a lot of famous bubbles in financial history. Right now, it looks to me as though the cryptocurrencies, most notably Bitcoin, are exhibiting bubble characteristics.  One sign of this is the enthusiasm of a particular football manager, one noted for his lack of financial acumen, for Ethereum.  I do not say this is a scam; I merely suggest that one should look to more fundamental underpinnings for value than “everyone likes it and it has gone up a lot.”

Avoid Conformity Bias and trade better by trading the other way when you see it happening.

https://www.routledge.com/The-Psychology-of-Successful-Trading-Behavioral-Strategies-for-Profitability/Short/p/book/9781138096288

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Author: Tim Short

I went to Imperial College in 1988 for a BSc(hons) in Physics. I then went back to my hometown, Bristol, for a PhD in Particle Physics. This was written in 1992 on the ZEUS experiment which was located at the HERA accelerator in Hamburg (http://discovery.ucl.ac.uk/1354624/). I spent the next four years as a post-doc in Hamburg. I learned German and developed a fondness for the language and people. I spent a couple of years doing technical sales for a US computer company in Ireland. In 1997, I returned to London to become an investment banker, joining the legendary Principal Finance Group at Nomura. After a spell at Paribas, I moved to Credit Suisse First Boston. I specialized in securitization, leading over €9bn of transactions. My interest in philosophy began in 2006, when I read David Chalmers's "The Conscious Mind." My reaction, apart from fascination, was "he has to be wrong, but I can't see why"! I then became an undergraduate in Philosophy at UCL in 2007. In 2010, I was admitted to graduate school, also at UCL. I wrote my Master's on the topic of "Nietzsche on Memory" (http://discovery.ucl.ac.uk/1421265/). Also during this time, I published a popular article on Sherlock Holmes (http://discovery.ucl.ac.uk/1430371/2/194-1429-1-PB.pdf). I then began work on the Simulation Theory account of Theory of Mind. This led to my second PhD on philosophical aspects of that topic; this was awarded by UCL in March 2016 (http://discovery.ucl.ac.uk/1475972/ -- currently embargoed for copyright reasons). The psychological version of this work formed my book "Simulation Theory". My second book, "The Psychology Of Successful Trading: Behavioural Strategies For Profitability" is in production at Taylor and Francis and will be published in December 2017. It will discuss how cognitive biases affect investment decisions and how knowing this can make us better traders by understanding ourselves and other market participants more fully. I am currently drafting my third book, wherein I will return to more purely academic philosophical psychology, on "Theory of Mind in Abnormal Psychology." Education: I have five degrees, two in physics and three in philosophy. Areas of Research / Professional Expertise: Particle physics, Monte Carlo simulation, Nietzsche (especially psychological topics), phenomenology, Theory of Mind, Simulation Theory Personal Interests: I am a bit of an opera fanatic and I often attend wine tastings. I follow current affairs, especially in their economic aspect. I started as a beginner at the London Piano Institute in August 2015 and passed Grade Two in November 2017!

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