Blog - Investing Notes

March 3, 2006 - The Illusionary Markets Hypothesis?

Can influential traders actively profit from the psychological biases, the not fully rational decisions, of others? In the January 2005 update of their paper entitled "Illusionary Finance and Trading Behavior", Malika Hamadi, Erick Rengifo and Diego Salzman introduce the concept of illusionary finance, based on the psychology of decision-making under time pressure and ambiguity, and analyze the creation and dissemination of illusions stock markets. They propose that:

• Time pressure and ambiguity tilt decision-making away from reasoning and toward intuition and quick-response biases (such as bounded rationality, framing effects and prospect theory).
• Illusionary traders create illusions by sending signals with ambiguous interpretation into the market to profit from the psychological biases of others.
• Illusions give superior information to their creators, because they are the only ones sure of the deception/misdirection.
• Even skeptics end up incorporating effective illusions into forecasts based on historical data.
• Simulation suggests that illusionary traders can profit from a simple strategy contrarian to the illusions, implemented only after the illusions show an impact. In other words they can win by selling (buying) after creating an effective positive (negative) illusion and then waiting for a opportunity to close the trade profitably.

In summary, stock market information warfare may be a winning strategy.

Perusal of Securities and Exchange Commission Litigation Releases suggests that discovered and litigated manipulations of stock prices most often involve the creation of positive illusions about small companies/stocks over extended periods by company insiders, who then benefit by contrarian selling.

Our blog entries of 1/30/06 and 6/16/05 examine, on a purely price-news/rumor basis, the possibility that short-sellers (as sources of bad news/rumors) anticipate the effects of negative mentions of stocks in Herb Greenberg's MarketWatch column.

For related research, see our blog entries of:

2/28/06 for a model of hedge fund-driven illusionary trading;

5/31/05 regarding the impacts of various types of information about companies on stock price;

2/6/05 examining the counterplay between active individual investors and rational speculators (smart traders) after attention-grabbing events; and,

12/29/04 finding that the media can be a market-destabilizing force.