Hank Pruden’s theory of "Behavioral Finance" proposes that human flaws are consistent, measurable and predictable, and being aware of and utilizing this phenomenon can benefit a trader. "For the better part of 30 years, the discipline of finance has been under the thrall of the random walk\cum efficient market hypothesis. Yet enough anomalies piled up in recent years to crack the dominance of the random walk.

Behavioral finance is "the use of psychology, sociology and other behavioral theories to explain and predict financial markets. Behavioral finance describes the behavior of investors and money managers and their interaction in companies and securities markets. It recognizes the roles of varying attitudes toward risk-framing of information, cognitive errors, lack of self-control, regret in financial decision-making and the influence of mass or herd psychology," said Pruden.

Predictable human behavior can and does impact markets, said Pruden. One example is the "crowd psychology" or "bandwagon" theory. For example, if a market is coming up from a basing area on the charts, "smart money" is responsible for the majority of the initial buying. "As people jump on board, we see the bandwagon effect, and that bandwagon pushes prices up. Volume tends to surge at its peak, certainly on the buy side, during the mark-up phase in the middle. Later on, toward the end of the trend, smart money is not doing the buying; somebody else is. The smart money is doing the selling. The market tops by curving over, or sometimes with a spike top. So, we can see express that in price and we can see under it in volume," said Pruden.

Regarding the type of trading approach to the bandwagon effect, Pruden said, "We align our indicators to show a distribution pattern or a breaking of trendlines, and we should see a post-volume peak. Volume will typically peak before a big change in sentiment."

Pruden said he puts time, price and sentiment together to come up with a composite to look at all those parameters at once. This composite would help in any trading decision, he said.

In the four major elements of technical analysis - price, volume, time and sentiment - recognizing and factoring in human behavior is certainly a major portion of the sentiment element, said Pruden.

Jim Wyckoff
TradingEducation.com