Life Cycle Model
Of Crowd Behavior
by Henry O. Pruden, Ph.D.
Behavioral finance adherents believe that markets reflect the thoughts, emotions, and actions of real people as opposed to the idealized economic investor that underlies the efficient market hypothesis. This longtime technician discusses this new field and the application of technical analysis as part of the framework.
For a large part of the past 30 years, the discipline of finance has been under the aegis of the efficient market hypothesis. But in recent years, enough anomalies have piled up, cracking its dominance of the field. As a consequence, the arrival of new thinking to explain market behavior has warranted attention, and its name is behavioral finance.
Behavioral finance proponents believe that markets reflect the thoughts, emotions, and actions of normal people as opposed to the idealized economic investor underlying the efficient market school as well as fundamental analysis. Behavioral man may intend to be rational, but that rationality tends to be hampered by cognitive biases, emotional quirks, and social influences.
Behavioral finance uses psychology, sociology, and other behavioral theories to explain and predict financial markets. It also describes the behavior of investors and money managers. In addition, it recognizes the roles that varying attitudes play toward risk, framing of information, cognitive errors, self-control and lack thereof, regret in financial decision-making, and the influence of mass psychology.
Assumptions about the frailty of human rationality and the acceptance of such drives as fear and greed have long been accepted by students of technical analysis. Indeed, in his Stock Market Behavior: The Technical Approach To Understanding Wall Street, Harvey Krow classified technical analysis in the behaviorist school of thought.
INTEGRATING TECHNICAL INDICATORS
Conceptual models stemming from behavioral finance can help the technical analyst construct and test systems of technical analysis. Further, the technician can harness his or her intuitive grasp of crowd psychology for practical application through the use of a modified version of a life cycle framework.
The framework I have in mind is the adoption-diffusion model of crowd behavior, illustrated in Figures 1 and 2. These figures show how a society adopts an innovation over time. The graph takes on the shape of a bell curve to represent the number of people adopting the change each period and looks like an S-curve when representing the number of people on a cumulative basis.
FIGURE 1: ADOPTION OF AN INNOVATION. The bell-shaped curve shows the number of people in a society that adopt an innovation in each period, while the S-shaped curve represents the cumulative number of people over time.
Excerpted from an article originally published in the January 1999 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.