There is a fiercely hot debate between practitioners & academics of finance on the topic of trends. In general, we casually accept that prices many-a-times put up significantly strong unidirectional movements with little or almost no pull backs & we love to call these movements as trend. In technical & statistical analysis, we try to devise various strategies to take advantage of trends or its reversal. But on the other hand, however odd it may sound, there is a different school of thought among the proponents of EMH (Efficient Market Hypothesis) that claims that prices are mostly random & trends are no more than a manifestation of that randomness. They claim that any profit derived from trend following is not because of the merit of the system but mere luck & it will be lost somewhere else.
Yes, we are aware of existence of numerous successful trend following strategies those have survived not years but many decades and they stand as evidence that trend following strategies do pick up certain inefficiencies in the prices over a longer run. But, what better way is there to refute this particular axiom of EMH than to explain the very reason of occurrence of trends? Behavioral Finance is a comparatively new branch of technical analysis that explains several inefficiencies in market, arising due to various manifestations of imperfect human psychologies. In this article, we take a look at one of many beautiful explanations of trend that Behavioral Finance offers.
University of Yale economist Robert Shiller believes that, all trends are analogous to Ponzi Schemes! What are Ponzi Schemes? They are pyramid frauds, named after infamous Charles Ponzi, who invented the idea in 1920s. The idea is to float a business model & promise investors a handful of returns. However, not a single penny of the investors’ money is put into work but the contribution of the new investors are used to repay old investors. This serves two purposes: one, the shabby business model gains credibility & two, the good story about a successful investment venture is spread by the initial investors & they are not lying. New investors keep coming in like moths enter into fire & the number of people influenced swells up exponentially. However, the end is equally dramatic. When the constant supply of new investors is exhausted & there is no money to repay old investors the model collapses like a house of cards.
The Shardha & Rose Valley scams that hogged limelight in recent past in Bengal & other parts of Eastern India are perfect examples of such Ponzi Schemes. But readers must not take solace into thinking that only the under-educated & less-privileged citizens of the society fall prey into such irrational marketing propaganda. We encourage the readers to Google the name Bernard Madoff or read the book ‘No One Would Listen’ by Harry Markopolos, CFA & learn how the largest ever Ponzi schemes in history ran for nearly 35 years in the city of New York & $25 billion worth of investors’ assets were duped. Rest assured, these investors were the creamy layers of the society and they still made very irrational choices. The apathy & inability on part of the Regulators to clamp down on such malpractices actually adds to the market inefficiencies. This is really how imperfect the world is.
Shiller argues that the speculative bubbles, that we call trends, are simply naturally occurring Ponzi Schemes in the market. They evolve, invite new investors, mature & then collapse all by themselves, even requiring no promoters as such. The salesmen of the street just make the story glossier by outlining the reward part of the investment & downplaying the risk part to the new investors. The same imperfect human nature that responds to the call of irrational Ponzi Schemes is also responsible for a trend to auto-feed itself till the point where new supply of losers exhaust. The similarities are strong & difficult to refute, indeed!
(Inputs taken with gratitude from: David Aronson, author, Evidence Based Technical Analysis)
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