Investment decisions using behavioral finance
It has often been said that people spend too much time studying investment behavior and not enough time focusing on investor behavior. Regardless of what an investment does, it is the decisions of the investor to buy or sell that ultimately determines success or failure. This fact is the underlying premise in behavioral finance.
Behavioral finance is about the odd behaviors that we exhibit when it comes to money. It took a very logical premise about the tradeoff between risk and return and added psychology.
Is psychology really important to investing?
To understand the answer to this question is to ask yourself how you feel about the markets today? If you are not feeling the emotions of concern, fear, frustration, desperation, panic and depression, then you would be considered either a very logical investor or one that has no clue about what is going on in the world today.
The fact of the matter is markets go in cycles, just like everything else. The reality is that every bear market is the beginning of a new bull market. It is also a historical fact that every bull market has lasted about 3 to 4 times longer than bear markets. Yet, despite these logical facts, emotion often gets the best of us.
Why is it we all tend to rush out and buy equities at the height of the market? Why is it that we tend to sell at the bottom of the markets when they are at their cheapest prices? When do we tend to buy the best performing investments?
Here are a few common examples of in the world of behavioral finance. If you can recognized these patterns of behavior, then you may have the fortitude to prevent emotions from getting in the way of investing.
- Innumeracy. This term refers to the inability for our minds to process problem solving easily. As a result, we tend to underestimate the frequency of randomness. Instead we label them as coincidence. If you flip a coin 20 times, what is the probability of flipping four heads in a row or four tails in a row? Most people think the odds are pretty low because they do not have a good sense of how easy it is for coincidences to occur. The answer is 50%. The key problem to innumeracy is we always try to develop patterns to investments, guessing as to when they will go up or down. The reality is there is a certain amount of randomness that occurs particularly in the short term.
- Mental short cuts. Our brain naturally develops mental short cuts otherwise known as rules of thumb. This helps our brain to organize and process information more quickly. For example, we tend to say we flipped a coin five times and the first four times we flipped a head. What is the probability that the fifth flip will be another head? Most people would say pretty slim but the answer is 50/50. The last flip is an event of it’s own. We tend to over interpret random events.A good example of this is when someone say’s “I’ll never buy a mutual fund again.” This tends to be an over generalization that all mutual funds are bad or risky. The reality is there are good funds and bad ones.
- Availability. You can’t make an informed decision without proper information and research. Unfortunately investors who make uninformed decisions are more susceptible to making poor decision fueled by emotion. The information that is most readily available tends to shape your behavior. The media is a good example of this. Which is more common, suicides or murder? Most people (around 70%) would answer murder but there are three suicides for every two murders in North America. What shapes our misconception is that the media reports way more murders than suicides.In the investment world, the media continues to play a huge role in shaping the availability of information. When times are good, headlines and news reports tend to be optimistic causing us to have an overly optimistic view of the future. The opposite is true when times are tough like today. The one thing to keep in mind is the media is a business and they are there to heighten out interest and our emotions.
In the next article, we will take a look at some more common behavioral traits when it comes to investing and money.