Pruden-Life Cycle Model of Crowd Behavior

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Articles: Life Cycle Model of Crowd Behavior Life Cycle Model of Crowd Behavior

BEHAVIORAL FINANCE

Life Cycle Model Of Crowd Behavior

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. by Henry O. Pruden, Ph.D. 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

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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 Sshaped curve represents the cumulative number of people over time.

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FIGURE 2: ADOPTER CATEGORIZATION The innovation dimension, as measured by time at which an individual adopts an innovation, is continuous. However, this variable may be partitioned into five adopter categories by
Figure 2 chart courtesy:M. ROGERS AND SHOEMAKER

laying off standard deviations from the average time of adoption.

For examples of crowd behavior, we can look at such classic cases as Tulipmania, the South Sea Bubble, and the Mississippi Scheme. The herd instinct of financial markets in these cases can be analyzed using the adoptiondiffusion model. The crowd phenomenon is also observable in market cycles of much shorter duration and smaller magnitude. Finally, recent observations in the news media reinforce the logic behind the use of a life cycle model of crowd behavior, drawing the link between technical analysis and behavioral finance models. CURVES, S-SHAPED AND BELL-SHAPED The herd instinct is reflected by the S-shaped curve of the life cycle model (Figure 1), while the bell-shaped model shows how groups of market participants may be positioned and interrelated, ranging from the smart money to those who enter the market last (Figure 2). Together, the two form a cycle model that can be used to organize indicators to gauge technical market conditions and to predict crowd behavior. In fact, economic theorist Theodore Modis argues that life cycle models can forecast the rise and fall of almost anything.

The adoptiondiffusion life cycle model, which is widely used in social science and in marketing research, can also be modified to fit the stock market. Using the

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model, Figure 3 shows how the four major parameters of technical analysis price, volume, time, and sentiment are interrelated. Further, the model can be used to specify and interrelate indicators to measure those parameters. It also reveals how these parameters can combine to form continuation or reversal patterns. FIGURE 3: THE PRUDEN MODEL The adoption-diffusion life cycle model is modified here to fit the stock market. Here, we see the four technical analysis parameters used in the decision-making process price, volume, sentiment, and time

FOUR ELEMENTS The four major parameters are a distinct aspect of the technical condition of the US stock market. Since the data for each parameter is independent from that of the others, the indicators representing them can be combined. This feature of price, time, volume, and sentiment is very important; it gives a more complete conclusion regarding the markets present position and probable future trend.

Further, indicators that represent each parameter can be arranged to provide a more indepth and reliable understanding of each parameter, as suggested in Figure 4. This can be used as a worksheet to aid in model development and testing. As can be seen, each element is broken down into three levels of analysis. The columns titled Indicators and Weighting are filled in by the

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analyst, with the entry depending on the market being analyzed and time frame selected.

Joe Granvilles tree of indicators concept comes into play during the building and testing of complex models. In this notion, rather than simply relying upon price trend and sentiment, the analyst can add together indicators such as price pattern, Elliott wave count, point-and-figure proportion, on-balance and total volume, and put-call ratio to fully exploit the technical information available. Using the adoptiondiffusion model, analysts can make sense of how these various parameters are tied together.

Depending upon the trader-analysts time horizon and confidence in certain indicators, an arsenal of specific technical indicators can be judiciously selected. If, for example, an analyst is an intermediate-term options or futures trader, then he or she might wish to examine the price parameter using stochastics or relative strength index (RSI) to study momentum, an hourly Dow Jones chart to count Elliott waves, and a point-and-figure chart of the DJIA to measure the potential extent of moves. These price indicators are seen positioned along the S-shaped curve.

With respect to volume, the analyst might include total daily New York Stock Exchange (NYSE) volume, a measure of overall upside vs. downside volume, and perhaps also a further refinement of an on-balance volume study of the 30 stocks in the DJIA. Volume is appropriately viewed under price on the bell-shaped curve.

Sentiment can be seen as measuring both the opinion and the behavior of various market participants. Sentiment indicators of opinion are captured by the feedback loop and indicators of sentiment behavior fit into the bell-shaped adoption curve. Here, the analyst might choose to evaluate market opinion by using the Investors Intelligence ratio of bulls to bears. In addition, he might evaluate prevailing sentiment using the headlines and leading stories from newspapers and magazines. He can then appraise speculative behavior by calculating OEX put/call open interest and volume ratios. Finally, the intermediate-term investor might utilize the fourth major parameter, time, by analyzing a 10- to 13-week trough-

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to-trough cycle, the duration spent in a given trend, and significance of seasonal influences or special days in the month.

By framing the indicators into the model shown in Figure 3, the trader can better judge when the odds are optimal to buy an upside breakout. The combined picture of price-volume-sentiment-time appears different in the lower-left quadrant (accumulation) of the model than in the upper right (distribution). One would want to buy every high-volume upside breakout in the former case, but not when the latter circumstances appear to prevail. Further timing clues are given by the classic bottom-reversal patterns in the lower left and the classic top-reversal patterns in the upper right.

The model also gives the trader grounds for establishing numerical benchmarks for entry and exit signals. These benchmarks can come from backtesting and real-time experience. Certain indicators can be given more weight, and the threshold levels between bullish, very bullish, bearish, and very bearish depend on the analysts choice of indicators, beliefs about the market, and experience.

The adoptiondiffusion life cycle model allows the technical trader to use the rich array of indicators available in software packages, at the same time avoiding being overwhelmed by data. As can be seen in Figure 5, small S-shaped life cycle curves build into larger ones. Thus, the model provides a systematic way of viewing and interrelating the daily, short-term, intermediate and long-term trends of the stock market.

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FIGURE 5: THE SHORTENING OF LIFE CYCLES. An overall S-curve pattern may consist of a long series of smaller S-curves. The life cycles indicated by the smaller S-curves become longer in the middle of the overall curve, then become shorter again. A successful technology will have a longer life cycle within the natural growth curve of a family of technologies. Toward the end of that familys natural growth, new products will come and go quickly. The shorter life cycles combine to form a larger cycle. GAINING AN EDGE The field of technical trading has become too competitive for a trader to blindly rely on a system that may no longer be feasible. Trading in the markets is fast approaching the levels of competition found in professional sports; we need something to help us gain that extra edge. Behavioral finance models can help us frame our technical information to gain that advantage.

Henry Pruden is professor of business and executive director of the Institute for Technical Market Analysis, Golden Gate University, in San Francisco, CA, as well as the editor of the Market Technicians Association Journal. He can be reached at Golden Gate University, 536 Mission Street, San Francisco, CA 94105, phone 415 442-6583, fax 415 442-6579, E-mail [email protected].

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FURTHER READING

Bazerman, Max [1998]. Judgment In Managerial Decision Making, fourth edition, John Wiley & Sons. Granville, Joseph [1976]. New Strategy Of Daily Stock Market Timing, PrenticeHall. Hartle, Thom [1998]. On a new market paradigm: Henry Pruden of Golden Gate University, interview, Technical Analysis of STOCKS & COMMODITIES, Volume 16: September. Investors Intelligence/Chartcraft, 30 Church St., New Rochelle, NY 10801. Krow, Harvey [1969]. Stock Market Behavior: The Technical Approach To Understanding Wall Street, Random House. LeBon, Gustave [1995]. The Crowd, Isis Large Print. Leonard, Brent L. [1996]. Answering the bell of sentiment indicators, Market Technicians Association Journal, spring-summer . MacKay, Charles [1995]. Extraordinary Popular Delusions And The Madness Of Crowds, Crown Publishing. Modis, Theodore [1994]. Life cycles: Forecasting the rise and fall of almost anything, The Futurist, September-October. Peters, Edgar E. [1991]. Chaos And Order In The Capital Markets, John Wiley & Sons. Pruden, Henry O. [1995]. Behavioral finance: What is it? Market Technicians Association newsletter and MTA Journal, September. Rogers, Everett M., and F. Floyd Shoemaker [1971]. Communications Of Innovations, Free Press. Schwager, Jack D. [1996]. Schwager On Futures: Technical Analysis, John Wiley & Sons. Statman, Meir [1998]. Behavioral finance, Contemporary Finance Digest, Financial Management Association. Thaler, Richard H., ed. [1993]. Advances In Behavioral Finance, Russell Sage Foundation. Figure 2 chart courtesy: M. ROGERS AND SHOEMAKER

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FIGURE 4: INDICATORS Three deep at every position Four elements: Price, volume, time, and sentiment Three levels of analysis, or three units of analysis for every element Element Unit Indicators* Weighting BullishBearish +4 +2 +1 -1 -2 -4 Price Momentum Extent Form Volume Total Upside/Downside On-balanced Time Cycle Duration Season Sentiment News Opinion Speculation *Indicators chosen by the analyst. Depending on the time frame used and the market studied, each technician can systematically select an array of specific technical indicators to represent each element of the model. 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. FIGURE 2: ADOPTER CATEGORIZATION. The innovation dimension, as measured by time at which an individual adopts an innovation, is continuous. However, this variable may be partitioned into five adopter categories by laying off standard deviations from the average time of adoption.

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FIGURE 3: THE PRUDEN MODEL. The adoption-diffusion life cycle model is modified here to fit the stock market. Here, we see the four technical analysis parameters used in the decision-making process price, volume, sentiment, and time. FIGURE 4: THREE DEEP AT EVERY POSITION. This form shows each element broken down into three levels or units of analysis. Entries under Indicators and Weighting depend on the market and time frame being analyzed. FIGURE 5: THE SHORTENING OF LIFE CYCLES. An overall S-curve pattern may consist of a long series of smaller S-curves. The life cycles indicated by the smaller S-curves become longer in the middle of the overall curve, then become shorter again. A successful technology will have a longer life cycle within the natural growth curve of a family of technologies. Toward the end of that familys natural growth, new products will come and go quickly. The shorter life cycles combine to form a larger cycle.

Henry O. (Hank) Pruden, Ph.D. Professor of Business and Executive Director, Institute for Technical Market Analysis Golden Gate University, San Francisco, CA. 94105

< top 536 Mission Street | San Francisco, CA 94105-2968 | 415.442.6583 | [email protected]

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