Introduction to Behavioral Finance | The motley madman
Investing is not just about numbers; these are the people behind the numbers. It’s also about understanding why the people behind the numbers act the way they do.
Armed with relatively simple concepts and understanding of behavioral finance and how people act, you can make better investments and make life-changing financial decisions. Let’s take a look at behavioral finance and its importance.
What is behavioral finance?
Behavioral finance is the study of how psychology influences investor behavior. Extensive research, initiated by Daniel Kahneman and Amos Tversky in the 1970s, has led to the discovery that many everyday heuristics, or mental shortcuts that people use to make decisions under uncertainty, are often suboptimal.
In other words, people are programmed to make mistakes when faced with uncertainty. Theoretically, by understanding this rationally, you might be able to avoid heuristic errors. You can also take advantage of such trends to profit from them.
Based on the theory developed by Kahneman and Tversky, a simple example illustrates a common irrational trend. Suppose you have in front of you the following two scenarios:
- You can choose between an 80% chance of winning $ 1,000 or $ 750 guaranteed. Which one do you choose?
- How about an 80% chance of to lose $ 1,000 or a guaranteed loss of $ 750?
If you took the guaranteed $ 750 on the first question, then 80% chance on the second, you answered like the overwhelming majority of respondents.
However, you would exhibit suboptimal behavior, as an 80% chance of winning $ 1,000 yields an expected return of $ 800. The $ 750 guaranteed is lower. Likewise, the 80% chance of losing $ 1,000 results in an expected loss of $ 800. The guaranteed loss of $ 750 is less.
In other words, investors tend to be risk-averse when faced with a positive outcome and seek risk when faced with a negative outcome. Consider these common examples of trading psychology: Have you ever wanted to make a quick profit (risk aversion) on a stock even though you thought it was worth more? Conversely, have you ever wanted to double (risk-seeking) a losing stock even though you thought it was now worth less than the current share price?
Behavioral finance seeks to explain the financial mindsets that underlie such investor behaviors.
Behavioral finance concepts
Other key concepts that shape investment decision making include herd behavior and mental accounting. As the name suggests, herd behavior refers to the tendency to follow a group in a decision rather than acting on the basis of your personal knowledge.
This is not necessarily a bad thing. After all, dynamic investing can be a worthwhile strategy. However, this can lead to investing in crowded positions with extended valuations that you are not comfortable with. Likewise, it can put you at undue risk like borrowing to speculate on housing around 2005.
Likewise, the concept of mental accounting, or the allocation of money to different mental accounts, can lead to irrational decision-making. It works in the sense that people are more willing to spend $ 50 to buy a theater ticket if they lost $ 50 in cash than if they lost the ticket worth $ 50. The reason being that they mentally count the price of going to the theater as now being $ 100 in the second case.
An example of investing is how you deal with a profit of $ 1,000 after reducing a winning stock position. It has the same value as $ 1,000 you earned while working. There is no reason to mentally explain it differently. But some people may treat the $ 1,000 profit differently and then speculate wildly with it because they have mentally accounted for it as bonus money.
Bias in behavioral finance
Armed with some essential knowledge, let’s take a tour of some common prejudices.
Confirmation bias: The tendency to search, filter, or analyze only information that confirms a predefined belief. In investing, this can lead to ignoring information that could lead you to modify your investment thesis.
Familiarity Bias: Only look at or overestimate the things you already know. For example, it makes perfect sense to buy shares in Coach if you love their brands and believe in the action. However, it does not make sense to avoid looking at the stock simply because it is now called Tapestry (NYSE: TPR).
Overconfidence bias: Have more confidence in your judgment than objective measurements warrant. Do you know how the consistency of the surveys shows that the majority of people think they are above average drivers? It is a prejudice that can hurt you when you invest in areas that are not within your expertise or knowledge.
Framing bias: The way information is presented can influence decision making. For obvious reasons, the management of a company wants to frame presentations in the most positive way possible. Therefore, it makes sense to systematically and objectively review what they are saying rather than taking it at face value. The same applies when reading financial news.
Anchor bias: The tendency to overweight the importance of an initial or key point of reference. If the investment thesis around a stock has changed and you now think the stock’s value is $ 100, it isn’t particularly relevant whether you bought the stock for $ 50 or even at $ 200. It doesn’t matter if you once thought the stock was worth $ 75 or $ 125.
Use behavioral finance to your advantage
Most of the above examples relate to unconscious biases in behavioral finance that can creep into decision making. In addition, investors may seek to take advantage of opportunities created by investors (i.e. the market) and their biases, as noted above.
For example, why not deliberately seek out stocks that are currently out of fashion since the herd won’t like them? Why not opt for a less publicized and / or under-researched action as a way to play up an investment theme or sector? There might be less familiarity bias built into the course of action. Likewise, if a trending industry or stock is consistently and consistently portrayed in a positive light, it might be time to start shying away from investing.
In these examples, investors can play both offense and defense with a basic understanding of behavioral finance.