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Behavioral Finance - Use The Investor Psychology To Your Advantage
By Sandy Naidu | July 26, 2008
The Text Book Approach To Investment
Theoretically stock prices are guided by the ‘efficient market hypothesis’. Here are the fundamentals of this hypothesis:
- The price of stocks already reflects all the available information.
- Investors behave rationally - they use the information available to decide whether to buy or sell a stock
If the markets were efficient all the time, then it would be impossible to beat the market. But there are investors who are consistently beating the market. So it can be said that the markets are neither perfectly efficient nor perfectly inefficient. Its somewhere in between.
Stock Market Anomalies
How does one explain boom, bust, huge price increases of a ‘hot’ stock or the huge demand for an IPO (which leads to excessive listing price)? There are no fundamentals driving such behavior. There is no new information that is causing the market to rise or drop in such excessive amounts. The above hypothesis cannot explain these movements. This is where ‘Behavioral Finance’ comes into play. Evidence shows that investors don’t always behave rationally - investors tend to exhibit irrationality and incompetency when faced with uncertainty.
What Is Behavioral Finance
‘Behavioral Finance’ is a discipline that studies the effects of emotions on people’s investment choices (particularly in the stock market).
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It uses psychology based theories to explain how investors’ emotions and mental errors can cause stocks and bonds to be overvalued or undervalued. Smart investors can make behavioral finance to work to their advantage. |
Investor Psychology And Behavioral Finance
Here are some of the concepts of behavioral finance:
OverConfident:Investors overestimate their stock picking abilities. This leads to excessive trading (because they tend to believe they are better than the others and hence can beat the market). They do not practice the ‘buy and hold’ strategy. Also the overconfidence makes the investors believe that their losses are due to bad luck. This will prevent them from learning from past mistakes.
Herd Like Behavior: Individuals follow the actions of a larger group (whether rational or irrational). The reasons for this herd like behavior are:
- Conformity - Conforming with the crowd is easier than going against the crowd. And hence most of us prefer to conform.
- The rationale that so many people can’t be wrong and so it is safer to be follow
This herd like behavior explains the booms and the busts we have witnessed in the past.
Our Attitude Towards Gain And Loss: People feel the pain of loss much more than they derive pleasure from an equal gain. People are basically willing to take more risks to avoid losses than to realize gains. They prefer selling good performing stocks to book a profit rather than selling poor performers to cut losses. Theoretically investors should be holding on to good performing stocks so that they can increase their profits and sell the badly performing ones so that they can reduce their losses.
This thinking leads most investors to hold on to badly performing stocks, with the hope that it will perform better (and it might never do).
Anchoring: Here are a couple of examples to show how Anchoring affects investors:
1. Investors refuse to buy a stock today because it had a much lower price last year (in the past)
2. Investors refuse to sell a stock because it was much higher in the past.
Anchoring can lead to undervaluing or overvaluing a stock. Our brain uses historical perceptions and past data to value the stock. Assume a stock was priced at $10 last year…This year the company suffered a significant market share and hence the price fell to $5. Anchoring can lead investors to stick to past data which will lead them to believe that this stock is undervalued (because last year it was $10 and now only $5).
Over and Under Reaction:Investors tend to give too much importance to the recent news rather than looking at the whole big picture.
Lessons From Behavioral Finance
1. Be patient
2. Don’t trade excessively
3. Exercise ‘Buy and Hold’ approach
4. Learn from past mistakes
5. Don’t panic
6. Erase historical prices from your mind - have an open mind
7. Use a value based investment approach to stocks
8. And here is the big one - Don’t be tempted to follow the herd
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August 17th, 2008 at 10:46 pm
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August 20th, 2008 at 1:02 pm
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