Psychology Over Physics In Today's Markets

| About: Vanguard FTSE (VGK)

A few, well quite a few, years ago I found myself selected by the bank I worked for to be on the interview panel for the graduate intake into their investment banking arm. I was convinced that most of the applicants' CVs were describing more than one person, so complete were they in achievement. It all made me feel very inadequate. This inadequacy was only heightened when I found myself sandwiched on the interview panel between a credit derivative expert who had been a top physicist and the head of our quant unit, who I thought I knew quite well, but through the feedback of the interviewees I discovered was a famous academic mathematician.

I had ended up in this position because I had requested graduate trainees for my group. I had also been told that I was exceptional as I had requested candidates with brilliance in psychology rather than physics. The HR department had even called to enquire whether my spell checker had misadapted 'physics' on my job specs. No, I wanted psychologists, ok, they also had to understand maths to some extent but psychology trumped physics or economics. I needed people who could read others; whether they were traders, clients or the whole market. Economics is a tool but it is only an input into decision-making and the timing of decision making is crucial in markets. Timing is probably an economist's greatest weakness.

The financial world has spent the last 15 years staffing themselves with mathematical geniuses but the actions that have caused the greatest disruptions to the global markets have not been mathematical but behavioural. "It has been emotional," as they say. Currently the state of the markets rests upon the outcome of a vote on the UK's membership of the EU. The way people vote is driven by a stream of inputs used to determine an outcome that is considered right. Right. Learning how to differentiate Right from Wrong is something that has engrained into us from the earliest of ages. Our parents' lectures, our tuition and every Disney film ever made are geared around training our 'right from wrong' instincts. But with the EU referendum there is actually no right from wrong. It's just a choice in the forest between two paths. Both lead off into the darkness of the future.

The markets are not about deciding which way we as individuals would go, but which way a group would go. If I were an observer trying to predict which path the group would decide to take and were allowed to employ either a physicist or a psychologist, I would hire the psychologist. Even with perfect information, group behaviour can deviate from expectation because of emotional feedback. The physicist would analyse the visible 10 yards of each path and assume the group would come to the same conclusions. How the group came to their conclusions as to where the paths finally end would be more greatly weighted by the characters within the group and how they interacted with the others, than the raw data.

There has been an emotional response to the news over the last 6 days. Opinion has been swung after Jo Cox's murder and Nigel Farage's immigration poster, neither of which has changed the underlying logic of belonging to the EU or not (a small sample set can be seen here). But the response in the markets has seen trillions wiped on to global asset values. Unforeseen by physicists, mathematical models or economists the response was instantly predicted by behaviouralists who rightly assumed (I was wrong) how the crowd would react. Behaviour is what drives price, not maths. Though the closest mathematical analogy I can draw is harmonics. Understand harmonics and you'll see patterns in the distribution, frequency and strength of the stories emanating from Jo Cox's murder. Yet overall, maths is purely an input that behaviour considers before pressing buy or sell, as logic is only a consideration to behaviour before ticking YES or NO in a referendum.

Behavioural economics is rightly taking off as a field. Economics is all about behaviour, right from a supply and demand curve which assumes a rational response to price (which if found to be wrong is excused through inelasticity, where inelasticity equals fudge), to price, where the best traders respond to how others are behaving rather than the technicals of price discovery. Hijacking others' behaviour is a sure-fire shortcut around analysis. Why else are the wires so interested in what others think? The best traders I have ever seen are the best psychologists rather than the best economists or mathematicians because who they are watching includes the mathematicians and economists as well as, more importantly, other people pressing buy or sell buttons.

So back to that interview panel I was sitting on. All the candidates had wonderful mathematical analytic abilities but many final decisions were based on the answers to questions, some of which I embarrassedly admit were far from orthodox, that elicited an ability to interact and read the future behaviours of others and adapt their own responses to maximise outcomes. Basically, social and psychological skills.

How are people now going to behave? On the basis that you fade all swings in expectation around a median of 'meh', this massive swing back to 'Remain' is probably best faded as, though logic remains logical, emotions fade. The emotional ADHD of the populace is only rivalled by my own. One other consideration is that now that voting 'Leave' has been emotional branded as making you a right wing murderous moron, it is much less likely that such a voter would declare such intention in an opinion poll.

I have rebought GBP puts and gone short FTSE.