A recent paper gives a summary of theoretical explanations of asset price properties (based on neurology) and reasons for trendfollowing strategies. Related to all trend-based strategies, mainly to:

#1 – Asset Class Trend Following
#144 – Trendfollowing Effect in Stocks

Authors: Bouchaud, Challet

Title: Why have asset price properties changed so little in 200 years

Link: https://arxiv.org/pdf/1605.00634.pdf

Abstract:

We first review empirical evidence that asset prices have had episodes of large fluctuations and been inefficient for at least 200 years. We briefly review recent theoretical results as well as the neurological basis of trend following and finally argue that these asset price properties can be attributed to two fundamental mechanisms that have not changed for many centuries: an innate preference for trend following and the collective tendency to exploit as much as possible detectable price arbitrage, which leads to destabilizing feedback loops.

Notable quotations from the academic research paper:

"Many theoretical arguments suggest that volatility bursts may be intimately related to the quasi-efficiency of financial markets, in the sense that predicting them is hard because the signal-to-noise ratio is very small (which does not imply that the prices are close to their “fundamental” values). Since the adaptive behaviour of investors tends to remove price predictability, which is the signal that traders try to learn, price dynamics becomes unstable as they then base their trading decision on noise only. This is a purely endogenous phenomenon whose origin is the implicit or explicit learning of the value of trading strategies, i.e., of the interaction between the strategies that investors use.

This explains why these stylized facts have existed for at least as long as financial historical data exists. Before computers, traders used their strategies in the best way they could. Granted, they certainly could exploit less of the signal-to-noise ratio than we can today. This however does not matter at all: efficiency is only defined with respect to the set of strategies one has in one’s bag. As time went on, the computational power increased tremendously, with the same result: unstable prices and bursts of volatility. This is why, unless exchange rules are dramatically changed, there is no reason to expect financial markets will behave any differently in the future.

Similarly, the way human beings learn also explains why speculative bubbles do not need rumour spreading on internet and social networks in order to exist. Looking at the chart of an asset price is enough for many investors to reach similar (and hasty) conclusions without the need for peer-to-peer communication devices (phones, emails, etc.). In short, the fear of missing out is a kind of indirect social contagion.

Neurofinance aims at studying the neuronal process involved in investment decisions. One of the most salient result is that, expectedly, human beings spontaneously prefer to follow perceived past trends. Various hormones play a central role in the dynamics of risk perception and reward seeking, which are major sources of positive and negative feedback loops in Finance. Human brains have most probably changed very little for the last two thousand years. This means that the neurological mechanisms responsible for the propensity to invest in bubbles are likely to influence the behaviour of human investors for as long as they will be allowed to trade."

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