High Frequency Trading: The Good, Bad and Ugly

Author : Prashant Rishi , IIM Lucknow

It was in late 2000, when the NYSE decided to quote prices of stocks in decimals of a dollar, as opposed to a fixed list of fractions.  The event (called decimalization) sowed the seeds of what is today popularly known as High Frequency Trading or HFT. Stated simply, HFT is trading in stocks by computers, with minimal human assistance. Carried out by super computers of major investment banks & hedge funds, high frequency trades range in time from less than a second to a few hours. Today, it is estimated that majority (~60%) of all equity trading in NYSE is done by trading algorithms. Although predominantly into equity, HFT firms have started moving into other asset classes, like derivatives, FX and fixed income instruments.

Figure 1: Asset classes traded by HFT firms

The obvious advantage that computers offer in trading assets is speed of processing information and executing trades. Add to it other advantages like low cost, high execution consistency & anonymity and you begin to understand why High Frequency Trading is so popular among all trading desks. 

Figure 2: Why funds prefer High Frequency Trading

Generally, trading algorithms are built on complex mathematics and statistical modeling. They are designed by Quants (as Math PhDs are known in Wall Street lingo). The hedge funds, who own these algorithms, protect them with as much zeal as Google protects its proprietary search algorithm or Coke protects its secret soft-drink ingredient. Most algorithms typically employ “flat” strategy, ie trading positions are closed within the same day. Profit with one such milliseconds-long trade is sometimes only a few pennies, but it is the massive trade volume that drives the total daily profits, which are in several thousands of dollars.

Players & Strategies

In the US equity markets, some of the highest volume high-frequency traders include proprietary trading desks of firms like Goldman Sachs, Knight Capital Group, Getco LLC & Citadel LLC. 

There are 4 basic strategies employed by almost every HFT firm:

Figure 3: Players in HFT space (US Equities)

Market Making

Traditional market making involves placing limit orders to buy & sell in order to earn the bid-ask spread. But for an HFT firm, the bid-ask spread is not the only source of money. Since market makers provide additional liquidity to the market by being counterparty to incoming market orders, they get rebates from exchanges for quotes that lead to execution. So, if an HFT’s bid (buy order) of $15 for XYZ shares is matched, it might immediately post an offer (sell order) for the same price, hoping to capture two rebates while breaking even on the spread. Building up such market making strategies typically involves precise modeling of the target market structure & trading volumes using stochastic control techniques.

Ticker Tape Trading

To appreciate ticker tape trading, it is essential to understand the concept of “co-location”. Co-location is a system wherein a stock exchange allows large hedge funds and i-banks to place their computers near its own data terminals, in exchange for rental income. Proximity to the stock exchange’s data centre ensures that any market movement (read the ticker tape) is detected by these computers before general public. Pre-designed algorithms can thus detect any trend in the prices, and carry out their own trades seconds before the general public even knows about the prices, and reacts to them. To realize the importance of a few seconds in computing terms, consider the case of Lotus Capital Management LP of New York. Earlier this year, it realized that a competitor was beating it to a trade it had programmed by exactly 3 microseconds, day after day. The loss meant Lotus was forfeiting about $1,000 in daily revenue on that particular trading strategy. Subsequently, that trading strategy was discarded since firm did not have the infrastructure to speed up the execution by 3 microseconds.

Event Arbitrage

Event Arbitrage is very similar to Ticker Tape Trading, except that the item of interest here is the news feed. Most HFT traders employ a class of algorithms to deal with each possible kind of corporate event (including earnings reports, earnings outlook, mergers and acquisitions, and analyst rating changes), and convert news into positive or negative trading signals. An example would be a very simple algorithm that would read words like “profit”, “confidence”, “beats expectations”, “good quarter” from a Reuters news flash, and would start buying the stock before general public have a chance to even finish reading the news. The trick is to be the one who makes the move first: to be the one who has the fastest news feed, the fastest information extraction algorithms and the fastest execution.

Statistical Arbitrage

Statistical Arbitrage strategies aim to make money by exploiting statistical mispricing of securities, like deviations in interest rate parity in forex markets. Carried out over prices of over hundreds of securities at a time, it is possible to detect such mispricing using extensive data mining & complex mathematical techniques. The arbitrage strategies hinge on the possibility that assets would obey their historical statistical relationships with each other in long run.

The Dark Side of HFT

There is another side of the story. High Frequency Trading is in the midst of a raging debate. Consider ticker tape trading as described above. A person who is privy to market prices before other players is called an insider trader, but if it is only a question of few seconds, the boundaries of law start to blur. Any firm with enough cash to buy high-tech infrastructure & pay rents to a stock exchange can enjoy the free lunch of being few seconds ahead of the market. HFT is, thus, accused by its critics to be a legal form of insider trading.

Now, consider market making. HFTs are in no obligation to provide liquidity to the markets. They do so to serve their own profit purpose (bid-ask spreads and rebates from exchanges). However, during periods of high volatility, these market making algorithms stop immediately, leading to an almost instantaneous erosion of liquidity. A perfect example of this phenomenon was Dow Jones Flash Crash on May 6, 2010, when DJIA plunged 900 points (9%) in 5 minutes, only to recover within next 10 minutes. A July, 2011 report by the IOSCO concluded that "the usage of HFT technology was also clearly a contributing factor in the flash crash event of May 6, 2010." Since then, many mutual funds have moved significant portions of their money out of US equity markets, and are considering other asset classes. They say that the US stock markets have been reduced to computerized gambling houses where algorithms devise microsecond-length trading strategies. All long-term valuation of business fundamentals seems to have lost its meaning.

And it’s not just equity. In February 2010, a trading algorithm owned by Infinium Capital Management ran amok and caused worldwide surge in oil prices by USD 1. The company currently faces civil charges for causing a global mayhem.

Of course, advocates of HFT (read hedge funds and investment banks) are quick to dismiss this criticism. They point that they provide the much-needed liquidity to the market, and hence improve efficiency of the markets. While regulators are vying to bring High Frequency Trading into the ambit of rules, there is undoubtedly a powerful lobby opposing this.

Figure 4: The Dow Jones Flash Crash of 2006

SEC recently passed a legislation banning the use of naked sponsored access, which allowed firms to trade directly on an exchange using a broker’s infrastructure without pre-trade risk controls. Similarly, IIROC, Canada’s financial regulator, has proposed new tariffs that would charge trading desks per message, rather than per executed trade. If these costs are passed down by trading venues to their members, it would have a marked impact on the execution fees paid by HFTs. What now remains to be seen is will these regulations prove effective in tightening the actions of HFT firms, or will the exodus of long-term investors from the US equity markets continue unabated.

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Private Equity-A pioneer for Sustainable Growth of India

Authors:Deepali Sharma & Sanchit Sawhney ,FMS

              

Introduction & History of Private Equity

The first PE fund was started way back in 1978 in USA by Kohlberg, Kravis and Roberts (KKR) which was based on the venture capital limited partnership model. The innovative PE model of western countries that was introduced to India got customized with time. The underlying logic on which the western PE model was based is the” inadequate or misallocated capital resulting in underperformance of businesses”. PE funds job is to search for such companies and to buy them with the purpose of providing cheap debt and institutional equity to the business and turn them around  by hiving off its unprofitable operations so as to resell the company to public at a higher price either directly (IPO) or indirectly (trade sale).Developing countries like India differ from the developed counterparts in terms of lacking the large, mature capital markets that not only provide PE funds their target firms, but also help them to attract foreign investors. In addition regulatory barriers in India further raised concerns for easy access to capital in scale resulting in undermined western model results. Indian businesses primarily controlled by families wherein the largest shareholders runs the firms as managers made any kind of disagreement between the two entities over the use of cash flow almost negligible forcing the PE Industry to adapt to Indian landscape by targeting unlisted firms that need capital to grow and expand.

KPMG Survey done in 2008 revealed the unique factor that differentiates India from other countries that is the requirement of overseas equity, corporate governance issues,  lower fund size, longer holding periods, above-market risk with higher expected returns. 

A Glance at the PE journey in India

Over the past decade PEs have adapted itself to Indian economy drawn by excellent growth opportunities in market-oriented environment in addition to increased number of entrepreneurs coming up constraint by lack of capital to expand their businesses as shown in the figure.

Figure above provides the snapshot of the performance of PE Industry in India.India has moved from the sixth position among the largest PE markets in the Asia-Pacific region (including Australia) in 2004 to the top spot by 2007 due to the macro fundamentals that suited the requirements of both PE investors and the Indian economy.

PE provided businesses with new source of capital, extensive network of connections and expertise in management. In return, Indian Businesses rewarded PE with exceptional returns with number of PE deals rapidly grew and reached the record levels in 2007 and 2008.The rapid takeoff of PE industry in India came to an end in second half of 2008 with the global financial crisis unfolded after US housing bubble collapsed that led to slowdown in global economy especially US and Europe. 

The 2007 Crisis & Impact

The impact of financial crisis started showing from the second half of 2008 when the euphoric results enjoyed by PEs in India have been mirrored by uncertainty in the financial world with the slowdown becoming more pronounced. As a result, PE in India witnessed a change majorly characterised by lower volumes and fewer exits due to the unwillingness of selling stakes at lower prices due to depressed market sentiments. However, India’s medium and long term potential remains intact backed by its strong domestic consumption that offers superior investment opportunity. By the second half of 2009 Indian economy bounced back. Private Equity in India has not recovered from recent financial downturn. Though fundraising fell by more than 70 percent in the first half of 2009 from its peak. Moreover, the credit crunch has made leveraging cost much more expensive. Thus, PE investors have  to play a more diligent & critical role.

Post Crisis

In 2010 Indian economy environment stabilized and price expectation become well below the peak in 2007 although comparatively high relative to developed markets, PE space regained strength in India. PE firms made 66 exits valued at US$2.1 billion in 2009 compared to 120 exits worth US$5.3 billion in 2010 according to financial research firm.Following Figure shows trends in PE investments with Deal both in terms of number & value in year 2011 signifying the rise of PE investments both in value & in number of deals from the Q4 of 2009 after the crisis.

Trends: Private Equity as a Pioneer for Sustainable growth

Sustainable Growth focuses on economic growth which is a necessary and crucial condition for poverty reduction. For growth to be sustained in the long run, it should be broad-based across sectors. Issues of structural transformation for economic diversification therefore take a front stage.  It should also be inclusive of the large part of the country’s labor force, where inclusiveness refers to equality of opportunity in terms of access to markets, resources and unbiased regulatory environment for businesses and individuals. Sustainability focuses on both the pace and pattern of growth.PE funds from around the globe are being lured by the enormous opportunities that are on offer in many sectors of the Indian economy. Factors that are boosting the inflow of PE funds:

• Sharp drop in stock market indices that have consequently resulted in a significant fall in stock offerings.

• Increase in interest rates that are making borrowings dearer, and tough Reserve Bank of India norms.

 Not surprisingly, most PE funds’ inflow into India has been in sectors that generally have a relatively long gestation period. According to IndusView, the real estate and infrastructure sectors accounted for 50 per cent of the total PE inflows in 2009.Still Private Equity has been successful in India, the main reason being dire need of their service much more than their money.  Companies in India have different reasons for wanting private capital depending on the type of company and what stage it is at, i.e. growing, seeking acquisitions, family owned, or a large corporate. For an example, first generation business builders look for private capital because they gain a considerable credibility and governance by having private equity representative on board. This in turn will help them while bidding for international contracts or attracting good talent.

The Indian Scenario-Inducing Sustainability

·   Aid the budding Entrepreneurs & act as partners than just fund providers:-In India where the situation is characterised by family-owned companies, 8000 companies listed on the stock exchanges, abundantly available capital, and yet a relative lack of liquidity in the market means that private equity companies will need to position themselves as partners than just fund providers if they are to become the preferred source of investment capital. These companies expect private equity firms to be able to add value, as required, in strategic, operational and human capital matters in addition to their financial contribution.

·    Labour Diligence:-Another issue addressed by private equity firms is due diligence. Much of the time spent on “demand diligence” is mostly irrelevant as companies already know there is enough demand and important question is whether the management can actually deliver or not. And to find out the answer they need to spend time on the shop floor for what can be called “labour diligence”. Most of the family-owned businesses have boards consisted almost exclusively of family members and friends. Private equity firms recognise the importance of finding outside directors who can provide the knowledge, environmental local expertise and experience necessary to help steer a company   through its next stage of growth or towards a public offering. For many companies, the board meeting is purely about compliance and the real debate and decision-making happens outside the meeting. Adjusting to a more rigorous style of board meeting can be extremely difficult for such companies. Private equity firms often play a strong influencing role in helping companies attract talent, commissioning search activity, and helping promoters to interview and assess talent & leadership.

·   Infrastructure/Real Estate & SEZ’z:-The Planning Commission estimates that India needs an additional $500bn over the next five years itself to finance infrastructure. Under the growing power and effect of global capitalists over third world nations like India, where the state has become an easy tool to facilitate these activities - huge investment for both industrial and non-industrial purpose from national and foreign investors are allowed. Land acquisitions are one aspect that draws a lot of controversial aspects related with question of national interest versus community interest. One of the decisive factors of fast growth of corporate sector is the impact of economic policies of liberalisation that have undergone a sea change in the two decades, starting from 1991. The underlying theory is to have a minimal reliability on state and more on market forces. PE has contributed by investing in such sectors & making them economically feasible in the interest of the nation. PE plays a key role critical growth driving sectors of the economy, As per Delloite Report the various sector wise requirements from PE are as follows:

Road ahead :

The Securities & Exchange Board of India(SEBI)  proposed new takeover rules that will make acquisitions by Indian companies easy and scrap the non-compete fee. The minimum holding requirement to trigger an offer to minority holders has been increased to 25% from 15% for a company. Once that level is reached, the acquirer must offer to buy 26% up from 20% now.

Implications-This move by the SEBI is in the right direction as it will lead to more participation from PE players both in terms of value and size of the deals and will also give the opportunity to increase their stakes in existing portfolio companies. This draft, if implemented, will also ease the difficulties faced by the listed companies due to 15% barrier for open offer. In Japan, the trigger for an open offer is 33.3 per cent, while in Hong Kong it is 30 per cent and in Singapore it is 29.99 per cent. In all three, the trigger requires an acquirer to make an offer for the entire company. The Achuthan Committee on Takeover Regulations had recommended that an open offer ought to be for all the shares (100 per cent) of the target company to ensure equality of opportunity and fair treatment of all shareholders no matter if they are big and small.On SEBI abolishing non-compete fees, companies woul d split the total pricing consideration (deal size) into a non-compete fee portion too so that the acquirer spent less on the total transaction cost. The fact is very often people with a considerable stake in a company signify some extra value for the acquirer ,that person could be a technology innovator, a progressive leader and/or manager with in depth understanding of the business and the environment, etc. A control premium/non-compete fee is often recognition of this reality. With non-compete fees abolished, what is likely to happen is that promoters may look to issue different classes of shares a practice that is legal in India, but almost never followed – to ensure a premium.The reduction of open offer size from 100 per cent to 26 per cent and scrapping of non-compete fees is a welcome balancing act.

Conclusion

Private Equity provides a unique edge so as to result in sustainable development of India. As per  Delloite survey various parameters that make PE a reliable companion for funding are shown :

To conclude the discussion, PE investments are not only a source of funds but also play the bigger role of the partner in taking the India’s companies to next level in terms of good governance, building capable executive teams, improving organisational capability, enhancing evaluations, creating liquidity and global competence. Private equity is developing into a major player in the Indian economy and there is a growing perception among Indian companies that private equity firms can add value on several fronts. With more and more companies setting up local offices and teams which work at the ground level, this industry will continue to be successful in the years to come.

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OPR Trading - Make profits even in turbulent markets

Author :Arun Prakash , BIM Trichy  

Introduction:

 “I can calculate the motion of heavenly bodies, but not the madness of people.”

                                                                                                -Sir Isaac Newton (1643-1727)

This was the statement made by one of the greatest geniuses known to us, when he lost around £3 million in present day terms in the stock market during the south sea bubble in 1720.

Time and time again the stock market has fascinated a lot of people all throughout the years. A lot have made their fortunes with it, and some have lost them while investing as well as trading on the stock market. However that is what constitutes the stock market, and that is what makes stock market returns more attractive than risk free investments. This article includes a brief description of the Open Range Breakout system and an original experiment conducted for testing the system in Indian Markets.

What is a Trading System?

A trading system is simply a group of specific rules, or parameters, that determine entry and exit points for a given security. These points, known as signals, are often marked on a chart in real time and prompt the immediate execution of a trade.

History:

The most famous example of a trading system is the one developed and implemented by Richard Dennis and Bill Eckhardt. In 1983, both had a dispute over whether a good trader is born or made. So, they took some people off the street and trained them based on the now-famous Turtle Trading System. They gathered 13 traders and ended up making 80% annually over the next four years. Bill Eckhardt once said, "Anyone with average intelligence can learn to trade. This is not rocket science. However, it is much easier to learn what you should do in trading than to do it." Trading systems are now becoming more and more popular among professional traders, fund managers and individual investors alike as it takes the human emotion out of the trading.

Candlestick basics:

The basic knowledge of candlestick charts is essential to understanding the open range breakout system. The candlestick techniques used today, originated in the style of technical charting used by the Japanese for over 200 years. This charting technique is very popular among traders.

Candlestick Components:

Like a normal bar chart, the daily candlestick line contains the market's open, high, low and close of a specific day. The candlestick has a wide part, which is called "real body". This real body represents the range between the open and close of that day's trading. When the real body is filled in or black, it means the close was lower than the open. If the real body is empty, it means the opposite: the close was higher than the open.

Just above and below the real body are the "shadows". Chartists have always considered them as the wicks of the candle, and it is the shadows that show the high and low prices of that day's trading. If the upper shadow on the filled-in body is short, it indicates that the open that day was closer to the high of the day. A short upper shadow on a white or unfilled body dictates that the close was near the high. The relationship between the day's open, high, low and close determines the look of the daily candlestick. Real bodies can be either long or short and either black or white. Shadows can also be either long or short. 

Open Range Breakout (ORB)

The Opening Range is a popular concept that was first introduced by Toby Crabel in his book “Day trading with short term price patterns and opening range breakout” (Crabel). It has since been further developed in a variety of ways in the literature by Geoff Bysshe, Mark Fisher and others. While OR is a powerful concept, there is no unified method to properly identify the price trends and the correct conditions to properly utilize them. Most of what is written on the topic consists of guidelines and suggestions with a few examples, but very few real performances or solid rules were introduced on how to create a successful OR strategy.

What makes the 30-minute Opening Range a powerful concept in trading is that it is the period during which traders act in response to recent news and observe the initial price movements of a particular stock with respect to the analysis they have done since the close of the prior day. The information gap between the opening period of the day and the prior period closing contributes to the significance of this strategy and makes it rich in information.

Geoff Bysshe also claims that about 35% of the time, the high and the low prices for the day occur within the first 30 minutes. This means that it is very likely that a stock will continue trading within the Opening Range and if its price breaks out it will continue to move in the direction of the breakout.

Design of the trading system

To design an Open range breakout system that would suit the risk profile of the user, the trader must determine the method of selection of stocks in which the system would be used, the entry criteria, the exit criteria and a stop loss criteria.

The Opening range can be set as a range from initial 30 minutes to an hour. Once the opening range time is over, the trader can enter into positions based on opening range high & low values.

Selection of stocks

The stocks which have huge volumes historically are the most preferred stocks for trading systems. To prevent including penny stocks, a price limit can be set. Liquidity is the single most important factor in choosing the stocks to trade.

Entry

Whenever the stock price breaks out of the opening range with two bullish candles closing above the opening range or two bearish candles closing below the opening range, a buy or sell call is generated respectively. If there are no continuous candles closing above or below the opening range, the signal is ignored. Also any entry signal during the last one hour is ignored as there may be no reasonable price change to exit the position.

Exit with Profit

The target for the long or short position of the stock can be determined by using the pivot levels. Numerous pivot value calculators are available on the internet like www.pivotpointcalculator.com from where target values can be determined by giving open, high, low &close price of the stock.

 Stop loss (Exit with Loss)

One of the important street knowledge on trading is that, traders must cut their losses short and let their winning positions run. The stop loss criteria can be designed as per the risk profile of the trader. A sample stop loss criterion can be 1% below the opening range high for buy calls and 1% above the opening range low for sell calls.

The following charts depict the long & short positions along with their entry & exit: 

          Buy Breakout:

           Sell Breakout:

Real time experiment in Indian markets

The open range breakout strategy was tested continuously for two months (25/04/2011 to 21/06/2011) by the author in the following manner. The author with an initial fictional investment of Rs 10,000 began to use the open range breakout strategy. The author tracked 10 stocks everyday and invested 10% of the capital in every call generated.

No real positions were taken and the study was carried out only for the research purpose. Over the two month period considering the transaction costs and leverage, the open range breakout trading system yielded a return of 79.99%.

The distribution of average daily returns of ORB for two months is depicted below:

Risk Return Ratios for the system:

Coefficient of Variation = Risk / Mean Return

                                    = 1.79

            Sharpe Ratio                = (Return – Risk free Return) / Risk

                                    = 0.55 (for a risk free rate of 6.5%)

Conclusion

"One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute."- William Feather (1889-1981)

In the current global economic scenario, with a possibility of US double dip recession looming, markets all over the world are facing tough times & huge volatility. The Open Range Breakout is an ideal trading system in such a scenario as it has potential to give better returns than the simple buy & hold strategy. Sensing the underlying trend in the market for the day, Open Range Breakout gives signal to the trader to take long or short positions in the market.

The essence of the open range breakout system is the way it captures the way information flows in the market. Most of the high impact information is released either after market hours or during the opening session of the market. The rules used in this trading system are universal and apply to broad range of financial and commodity markets.

The open range breakout trading system yielded a return of 79.99% while S&P CNX Nifty Index for the same 2 month test period gave a return of -10.19%

A drawback of the ORB is that, the delay in execution may lead to prices moving away from the ideal entry point and thus will reduce the potential returns. However, this drawback can be rectified by automating the trading system, i.e using computer programs to trade.

The simplicity of ORB makes it a potential candidate for algorithmic trading. With a high Sharpe ratio of 0.55, ORB trading system can be adopted by institutions in India, as in the developed markets. Even though algorithmic trading is still at nascent stage in India with just 20% of the total cash market volume, it has greater role to play in the future global Indian Markets.

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Behavioral finance - Logic, Psychology, Economics & More ! ! !

Author :Rachit Srivastava , NMIMS 

Economics is probably the science that arguably has had the most impact in today’s times. In fact it can barely be called a science in a strict sense, since human behavior is not governed by laws of nature unlike other non living objects, which makes the prediction and forecasting stock prices, economic conditions  all the more difficult.  In recent decades economists have tried to give a more structured and mathematical explanation to their theories concerning how human beings make their decisions. However these theories have come under immense criticism as they don’t hold true in real time. In reality, human beings rarely behave rationally which is the basic assumption in many of the economic theories; rather we make a lot of our decisions based on our intuition and limited knowledge available to us. When the financial crisis of 2008 came upon us, a lot of questions were raised on the apparent predictive abilities of the various economic theories. Merely 12 economists were able to foresee the massive crisis which now shows signs of deepening into a double dip recession.

Since then economists have looked at alternative theories to explain and predict the real world dynamics. This is where the behavioral economics comes in. Among other things, it seeks to explain why humans behave how they behave, what are the impacts of this in the economy (here we are particularly concerned with financial markets), how we can avoid various biases to make better investment decisions.

What is the role of investor’s confidence in the financial markets? Why a downgrade of the US treasury sends ripples in the stock markets all over the world .How do investors react to such kind of information? Do we take all the information into account before making an investment decision?  Can we really predict the stock prices?

In 1985 Werner Bondt and Richard Thaler published a research paper “Does the stock market overreact?” forming the start of what has become known as behavioral finance. They discovered that people systematically overreact to unexpected and dramatic news events results in substantial weak-form inefficiencies in the Stock market. This was both surprising and profound.

Behavioral finance is a relatively new branch of economics which is gaining acceptance in the academic as well as non academics world. In simple language, is seeks to explain how various social and psychological attributes of human beings  affect their behavior, particularly decision making, while making financial and investment decisions. What drives us to make seemingly rational yet blatantly irrational decisions?  For example; even when people were constantly warned by experts that Speak Asia, an alleged market research company was nothing more than a Ponzi scheme, they still invested money in it. What drives this brave risk taking behavior on one hand and loss aversion on the other?

An interesting TED talk by Dan Ariely points this flaw in humans out, “Are we control of our own decisions” he asks. The crux of his point was that human beings have a very strong tendency to make decisions not in absolute, but in relative terms. Dan Ariely is a behavioral economics professor at MIT, a very interesting experiment he did to prove his point was as follows: He presented the students at MIT with the following economist newspaper subscription advert.

	Subscription Type	Subscription price (Yearly subscription in $)	Percentage of students who took the option.
1.	Print only	75	16%
2.	Online only	125	0%
3.	Print and online both	125	84%

 

He then did the same experiment again, only this time he removed option number 2;

	Subscription Type	Subscription price (Yearly subscription in $)	Percentage of students who took the option.
1.	Print only	75	75
2.	Print and online both	125	35

That point that he makes here is that when there was option 2 present , we not only tend to compare between option 2 and 3 but we also tend to ignore option one ,thus reaffirming the fact that we  think relatively. This can have potential impact on the way investors and brokers choose portfolios etc.

How do human beings look at random events? There have been numerous theories in the field of risk analysis and psychology about randomness, both measurable and non measurable. Yet human behavior assigns value to random events which are not rational. Nicholas Taleb has captured the essence of how human beings respond to random events in his bestseller “Fooled by Randomness”. Among other things he talks about how human beings attribute their success to themselves and hard work and failures to others performances, how we focus  more on one success story and ignore thousands of failures ( survivor ship bias) ,how we tend to respond differently when the same scenario is presented to us in different forms, and so on. In his other book The Black Swan Prof. Taleb talks about how we perceive and ignore to some extent highly improbable events which have a huge impact , e.g.; financial crisis.

Anchoring, one of the most evident biases occurs when our brain gets fixated on the first information that we receive. For example, a professor asks two kids to estimate the pop of country xyz and the first one gives the answer 10 mn. Now it is almost certain  that the second boy would give an answer which would be very close to 10 mn or very far away, because he got hinged on the figure 10 million.  

People also tend to act “foolishly” when it comes to picking portfolios. A research done by The Economist newspaper through an investment research firm about how good people are at picking portfolios showed that people particularly in U.S chase fads. The statistics showed that investors tend to invest in funds that have had strong returns in the past 12 months. But, these popular funds lost steam subsequently and performed lower than the average. The statistics showed that the most popular sectors declined in terms of returns after people invested heavily in them.

We now move to another aspect of human behavior, which is loss aversion. Loss aversion is the human tendency to value losses more than proportionate gains, that is, they assign a value to loss which is higher to the value assigned to a gain of equal amount. Risk has been central to trading not just in the financial markets but in the olden days as well. Multiple theories are present to show how humans judge risk, how they accept some gambles and reject others. There was the expected utility hypothesis, which stated that we ascertain whether to take a bet or not on the basis of utility derived.

Another theory by Daniel Kahneman and Amos Tversky called the Prospect theory, explains how humans attach values to different gains and losses rather than the final outcome, and thus take or avoid risk. They say that since human beings derive different utility from the same event and they tend to value outcomes that are certain more than uncertain outcomes. In general empirical studies have shown that humans are risk averse, and they value loss more than gains from a bet, which means that wealth shows diminishing marginal utility.

There is a lot of research work going on in this particular field, more so since the crisis of 2008. The purpose of this article was to make readers aware of the subject .Behavioral finance is an interesting mix of logics, psychology and economics. Budding investors and management students should look into this in more detail so that they are better equipped to make financial decisions.

 

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