How Behavioral Finance Could Make You a Better Investor
Markets would be easy to predict if humans were not involved
If you’ve ever bought or sold stocks, there’s a chance you may have done so based on feelings and emotions rather than cold, hard evidence.
You may want to believe you trade based on objective information, keeping an eye focused intently on your investment goals. But you’re human. You buy a stock because you saw a pundit talk about it on television. You sell a stock because it’s lost some value and you’re freaked out.
You’ve probably bought or sold stocks simply because it feels good to make a transaction.
Even if you haven’t traded based on emotion, there may be other instances where you didn’t make the optimal investment choice due to a lack of information.
Behavioral finance is a new field of study that examines this phenomenon. It looks at psychology and emotion, and seeks to explain why markets don’t always go up or down the way we might expect.
Conventional or Traditional Finance
People have been studying business and finance for years. As a result, there are many theories and models that use objective data to predict how markets will respond under certain circumstances. The Capital Asset Pricing Model, efficient market hypothesis, and others have a reasonably good track record of predicting the markets. But these models assume some unlikely things, such as:
- Investors always have complete and accurate information at their disposal
- Investors have a reasonable tolerance for risk, and that tolerance does not change.
- Investors will always seek to make the most money at the greatest value.
- Investors will always make the most rational choices.
As a result of these faulty assumptions, conventional finance models don’t have a perfect track record.
In fact, over time, academics and finance experts began to notice anomalies that conventional models could not explain.
If investors are behaving rationally, there are certain events that should not happen. But they do. Consider, for example, some evidence that stocks will have greater returns on the last few days and first few days of the month. Or the fact that stocks have been known to show lower returns on Mondays.
There is no rational explanation for these occurrences, but they can be explained by human behavior. Consider the so-called, “January effect” which suggests that many stocks outperform during the first month of the year. There is no conventional model that predicts this, but studies show that stocks surge in January because investors sold off stocks before the end of the year for tax reasons.
Accounting for Anomalies
The human psychology is complex, and it’s obviously impossible to predict every irrational move investors might make. But, those who have studied behavioral finance have concluded that there are a number of thought processes that push us to make less-than-perfect investment decisions.
- Attention Bias: There is evidence suggesting that people will invest in companies that are in the headlines, even if lesser known companies offer the promise of better returns. Who among us hasn’t invested in Apple or Amazon, simply because we know all about them?
- National Bias: An American is going to invest in American companies, even if stocks overseas offer better returns.
- Underdiversification: There is a tendency for investors to feel more comfortable holding a relatively small number of stocks in their portfolio, even if wider diversification would make them more money.
- Cockiness: Investors want to believe they are good at what they do. They aren’t likely to change investment strategies, because they have confidence in themselves and their approach. Similarly, when things go well, they are likely to take credit when it fact their good results come from outside factors or sheer luck.
How It Can Help You
If you want to become a better investor, you will want to become less human. That sounds harsh, but it will benefit you to take stock of your own biases and recognize where your own faulty thinking has hurt you in the past.
Consider asking yourself tough questions, like, “Do I always think I am right?” or “Do I take credit for investment wins and blame outside factors for my losses?” Ask, “Have I ever sold a stock in anger, or bought a stock based on a simple gut feeling?”
Perhaps most importantly, you must ask yourself whether you have all of the information you need to make the right investment choices. It’s impossible to know everything about a stock before buying or selling, but a good bit of research will help ensure you’re investing based on logic and objective knowledge rather than your own biases or emotions.
Consider a Robo-Advisor
One of the latest trends in investing is the use of robo-advisors, in which a company manages your investments with very little human intervention. Money is instead managed through mathematical instructions and algorithms. Some major discount brokerages including Vanguard, E-Trade and Charles Schwab have robo-advisors services, and there are a number of newer companies including Betterment and Personal Capital.
The jury is still out on whether robo-advisors offer above-average returns. But in theory, using a robo-advisor will enhance your chances of making optimal and rational investing decisions. Moreover, as more investors turn to this automated approach, we may see the conventional finance models become more accurate as human behavior plays less of a role in how markets perform.