Tomer Solel is a Financial Analyst at I Know First. He graduated from Cal Poly Pomona with a bachelor’s degree in applied mathematics.

Algorithmic Trading vs Mass Psychology

Summary

Investors use different ways when investing in the stock market.

Mass psychology is the way in which investors follow trends.

The findings of Kahneman and Tversky show us examples of the use of mass psychology.

Algorithmic trading uses computerized technology in investing.

I Know First uses an advanced predictive algorithm in its forecasts.

Introduction

There are many different ways for individuals to pick what stocks they invest in. On October 29, 2012, Dr. Lipa Roitman wrote a Seeking Alpha article, in which he analyzed stock picking. He declared that some people look in the news, others look at products they like, or at a balance sheet. There are fundamental analysts, technical analysts, and the most advanced method of algorithmic trading. But what effect does mass psychology have on our financial decisions? How are algorithms used to make more sophisticated predictions about the stock market? This article will discuss the use of mass psychology in investing with a comparison to investing with the use of algorithms. In mass psychology, we go with the flow, we follow trends and go after the leader. In algorithmic trading, we use computerized models to predict the stock market. At I Know First, we have an advanced predictive algorithm to forecast the stock market.

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Mass Psychology in Trading

Being a good investor takes a lot more than just being good with numbers. There are a lot of hidden depths that define the stock markets. If financial markets were only based on numbers, good traders would not need nearly as much education and knowledge. Psychology is a big key to success. Investors need to use their instincts when making decisions, rather than using their emotions. The level of success for individuals in the stock market is heavily leaned upon human psychology in uncovering random events in the stock market. The root of this comes from a Chinese philosophy known as Taoism. This is a theory that recognizes that the world and its aspects may be evolving, but the phenomenon that dictates this evolution stays put. That enables investors to operate to a more in-depth understanding of the environment, not just based on emotions or sudden changes in price. These strategies have been used by many successful investors, arguing that human psychology is more valuable than any form of analytics. Traders need to use data that they are self-aware of, and they also need a basic understanding of the market they are investing in. As a result, markets have a tendency to conform to the average. The psychology of individuals is to copy one another, leading to what’s known as conventional judgment. A problem with this is that because humans are so error prone, financial markets are somewhat inefficient. Another aspect of psychology is the aspect of greed. Most investors in the trade market seek risk in one way or another. That is not necessarily a negative thing, as being too cautious can cost you opportunities in life. Hope and profit are other factors that traders take into account, as one always hopes to maximize his/her profits. The last factor is that of fear, as no one likes losing money, resulting in some people either not investing, or even going bankrupt. Human psychology is still an understated aspect of trading, but it has a huge effect on any traders throughout the world, as it is still widely used by investors.

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The Findings of Kahneman and Tversky

Daniel Kahneman is an Israeli-American psychologist, known for his work in behavioral economics, for which he was awarded the Nobel Memorial Prize in economic sciences. Along with his colleague Amos Tversky, the two established a basis for common human errors that arise from biases. They used to focus illusion to explain this bias. In that, they said that when people consider the effect of one specific factor on their overall happiness, they exaggerate that factor while overlooking other factors which could have a greater effect. This phenomenon could be applied to investing, as investors sometimes don’t look at the whole picture, aiming to explain our irrational economic choices. Another phenomenon that Kahneman discovered with Tversky was ambiguity aversion. They said that people are only ambiguity averse when their attention is specifically brought to the ambiguity by comparing an ambiguous option to an unambiguous option. This also applies to economics, as when it is possible to compare the ambiguous gamble to an unambiguous gamble, people are averse; but not when one is ignorant of this comparison. These examples are another proof that investors use mass psychology when picking their stocks.

Algorithmic Trading

In recent years, the use of algorithms has become more and more common as computers have taken over the world. We now have automatic trading that is done in high frequency. Some different factors that make these computerized devices great include great timing, price, quantity, and mathematical models. They have completely changed the microstructure of the market. This uses programmed algorithms to execute orders precise to milliseconds, raising the liquidity of the markets. It is widely used by banks, mutual funds, pension funds, and other industries. It can be used both for investing, and for trading. This use is more systematic, as it takes the bias concept out of the equation, as there is no emotion involved at all. Because of that, computerized methods reduce the role of psychology, and there is a separation between those who use algorithms and those who still persist on using other methods. There are different opinions regarding the use of algorithms, as some traders already rely heavily on them while others argue that the use of computers with the lack of direct human interaction could be detrimental over time. Algorithmic trading is most commonly used by large institutional investors who purchase a large number of shares on a daily basis. These algorithms allow these investors to obtain the best price without increasing purchasing costs. Even in Wall Street, algorithms have taken control. The Dow Jones launched a new service which sends real time financial new to professional investors. But some of the aforementioned investors are not actually humans, they are algorithms, which use data, not news. Algorithms are now an essential part of the stock market.

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Conclusion

In conclusion, mass psychology and the use of algorithms are two different methods to invest in the stock market. Mass psychology refers to going with emotions, following the news, and utilizing other resources when making investment decisions. As a corollary, a sharp observer who recognizes the bias inherent in mass psychology would try to use it to his advantage by going counter-trend: he would buy when everyone is selling, and sell when the crowd is buying. This contra-strategy could work in a long run. The risk is, he does not know when the bias turns direction, and meanwhile, the trader may suffer losses.

On the other hand, algorithmic trading is the newest, advanced form of trading, which uses computerized technology. It is extremely unbiased, it does not use emotion, and is able to predict the chaotic waves that might appear in the stock market. At I Know First, we use the algorithmic method. We have an advanced, predictive algorithm which is used to forecast the stock market. We offer subscribers stock market predictions for 6 different time horizons in the short and long term, with both signal and predictability. Forecasting the markets is a very difficult challenge because of how chaotic they are, but the algorithm lets us focus on the right opportunities. It is a tool that helps us make informed investment decisions.