Workshop 1

THE PACIFIC FUTURES TRADING COMPANY

For some time, theoretical and empirical evidence suggested that the Efficient Market
Hypothesis, the Capital Asset Pricing Model, and other rational financial theories did a good
job of predicting and explaining the behavior of investors. However, recently, the ‘rationality’
of financial markets - and more specifically investors - is a hot topic in the financial
economics literature. Recent research has argued and shown that investors often make
mistakes; they behave irrational and exhibit a number of financially damaging biases, such
as loss aversion, herding, overconfidence, and overreaction (Barber and Odean, 2001;
DeBondt and Thaler, 1986; Fischoff and Slovic, 1980; Gervais and Odean, 2001; Huberman
and Regev, 2001; Kahneman and Tversky, 1979). These irrationalities are frequently
attributed to psychological factors such as fear, greed, regret, and other emotional
responses to price changes and changes in personal wealth. A growing number of
economists, psychologists, and financial-industry professionals have begun to use the terms
‘behavioral economics’ and ‘behavioral finance’ to differentiate themselves and their ideas
from the standard, rational theories (such as the Efficient Market Hypothesis) in economics
and finance.

Akrisios Stathopoulos is the President of the Pacific Futures Trading Company (PFTC).
Futures trading is a form of investment which involves speculating on the price of a
commodity, such as gold, cotton, wheat, or steel, going up or down in the future. Futures are
popular instruments amongst traders, from private individuals through to multi-million dollar
hedge funds. Founded in 1972, the Pacific Futures Trading Company is a second generation
family owned business. With Akrisios as President, his brother Epifanio as Vice President of
Finance, and his other brother Sirius as Vice President of Human Resources, the
Stathopoulos brothers are strongly committed to creating customer satisfaction.

Like futures trading, the Pacific Futures Trading Company has grown exponentially over the
last decade. Hence, the company spends a lot of time and money on recruitment and
training. In futures trading it is crucial to attract, screen, and select qualified people for the
job and then to train these new employees to become successful traders. To be a
successful trader takes patience, but also determination, discipline, and education. Indeed,
learning how to trade is a process that takes time.

Despite the efforts that the Pacific Futures Trading Company has put into recruitment and
training programs, its traders (even the most experienced ones) occasionally exhibit
powerful emotional responses during certain market events, such as increased price
volatility or sudden breaks in trends. As a result of these emotional responses, they
occasionally make mistakes. Every now and then these mistakes have a profound financial
impact on the company, its clients, and/or the trader.

Over the years, Akrisious Stathopoulos has become increasingly interested in the effect of
personality characteristics and emotional reactivity on the trading performance of investors.
He has recruited, Sam Beam, a student from Cambridge to investigate the role of personality
and emotions on trading performance.

To find solutions for Akrisious’ problem Sam has gathered initial information about factors
that are possibly related to the problem. He has interviewed several traders of the Pacific
Futures Trading Company and gathered books and research articles on behavioral
economics and finance. Hence, he has developed a feel for what is going down in the field
of behavioral finance. This has allowed him to develop the following problem statement:
“What is the effect of personality and emotional reactivity on the financial performance of day
traders?”

After Sam and Akrisious agreed on the purpose of Sam’s research, Sam started examining
specific variables as to their contribution on the financial performance of day traders. He
developed a theoretical framework that represents his beliefs on how certain variables are
related to financial performance and an explanation of why he believes that these variables
are associated with financial performance. From this theoretical framework, he has
developed the following hypotheses to examine whether his theory was valid or not:

H1: Extreme (positive and negative) emotional responses to market events have a
negative effect on the trading performance of investors.
H2: Successful traders tend to be emotionally stable introverts who are open to new
experiences.

To test these hypotheses Sam recruited 50 volunteers from a six-week training program for
day-traders offered by Rose Bush, a well-known professional futures trader. The day-traders
were asked to complete a questionnaire that recorded their psychological profile before the
training program. During the training program day-traders were asked to fill out
questionnaires at the end of their training day. These questionnaires were designed to
measure the participants’ emotional state and trading performance for that day. Sam used
the following scales to operationalize the variables in his model: Zung’s Self-Rating Anxiety
Scale and Self-Rating Depression Scale, a public domain version of McCrae and Costa’s
NEO IP-R personality inventory instrument, the UWIST Mood Adjective Checklist, and the
total profit/loss on paper trades for the day.

After the data were gathered they were statistically analyzed to see whether the hypotheses
that were generated were supported. The results from Sam’s study support his first
hypothesis. For Sam, these results indicate that there is a clear link between emotional
reactivity of investors and trading performance. These findings suggest that traders may
benefit from training in emotion management and coaching. By acquiring emotional
management skills and techniques, traders may be able to better understand the impact that
their emotions have on their behavior and performance. Also, it may provide them with
techniques to better manage their emotions and hence to improve their performance. No
evidence was found to support the second hypothesis. This suggests, Sam explained, that
traders with different personality types may be able to function equally well after proper
training and practice.

QUESTIONS

1. In terms of basic research and applied research how would you categorize Sam’s
study? Why?
2. Purposiveness, testability, and objectivity are three hallmarks of scientific research.
Use Sam’s study as an example to discuss these hallmarks.
3. Do you think that the results of Sam’s study are generalizable to other organizations?
Why (not)?
4. Sam has explained to Akrisious that even though he has tried to meet all the
hallmarks of scientific investigation, he has not included all the variables that
influence the financial performance of traders. Using vocabulary Akrisious has never
heard of (such as omitted variable bias and biased and inconsistent parameter
estimates) Sam argues that his study may lack rigor and that therefore his study is
probably not 100% scientific.
a. What is rigor?
b. Do you think that despite the apparent lack of rigor, Sam’s efforts have
still been worthwhile.
5a. Inductive and deductive reasoning are key elements in research. Describe these
processes in detail.
5b. How does Sam use induction and deduction in his study?
6. Explain the steps in hypothetico-deductive research using Sam’s study as an
example.

REFERENCES

Barber, Brad M., and Terrance Odean, 2001, “Boys will Be Boys: Gender, Overconfidence,
and Common Stock Investment,” Quarterly Journal of Economics, 116, 261-292.
De Bondt, Werner F.M. and Richard H. Thaler, "Further Evidence on Investor Overreaction
and Stock Market Seasonality" Journal of Finance 42, (1987): 557-581.
Fischoff, B., & Slovic, P. (1980). A little learning . . .: Confidence in Multicue Judgment
Tasks. In R. Nickerson (Ed.), Attention and Performance, VIII. Hillsdale, NJ: Erlbaum.
Gervais, Simon, and Terrance Odean, 2001, “Learning to Be Overconfident,” Review of
Financial Studies, 14, 1-27.
Huberman, G., & Regev, T. (2001). Contagious Speculation and a Cure for Cancer: A
Nonevent That Made Stock Prices Soar. Journal of Finance, 56, 387- 396.
Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision Making
Under Risk. Econometrica, 47, 263- 291.