How Behavioral Finance Can

Strengthen Your Investments

Using Psychological Theory With Financial Concepts To Avoid Making Irrational Decisions With Your Money

“The investor’s chief problem - and even his worst enemy -

is likely to be himself.”

- Benjamin Graham

 

Anomalies That Led To Behavioral Finance’s Development

Sell-off of poorly-performing stocks in December for tax purposes.

The JanuaryEffect

• January market rebounds after the correction.

In theory, stocks should have a higher level of risk than they do.

The Equity Premium

Puzzle• The discrepancy between the risk levels of stocks and bonds is due to

the false perceptions of investors.

Finance and economics assume investors won’t pay more for something than it’s actually worth.

The Winner’s Curse

• The same phenomenon is seen in competitive markets.

The Eight Key Concepts in Behavioral Finance

These eight central ideas in behavioral finance fuel poor financial decision-making.

Consider whether or not you’ve ever fallen victim to any of them. Nearly everyone can recognize some familiar aspect from their past.

Anchoring

Anchoring occurs whenever you base many of your financial decisions on particular facts or ideas that you believe are relevant.

But sometimes, the very “facts” you’re using may be irrelevant or even inaccurate.

Faulty anchoring is likely to take place when we encounter situations that rarely occur.

More About Anchoring

Diamond Anchoring

• An old rule was that we should spend two months’ salary on an engagement ring.

• Why follow a rule set by the jewelry industry?

Anchoring In Investments

• Some investors assume falling stock prices are due to basic volatility.

• But what if it’s falling because the company is floundering?

How To Avoid Anchoring

• Use logical and critical thinking skills and base decisions on facts.

Overconfidence

Overconfidence and Investing

Investors with the highest confidence levels make a greater number of trades than those with less confidence.

These same overconfident traders also consider themselves to be exceptionally good traders.

However, the reality is that a high portfolio turnover tends to lead to poorer than average results.

Preventing Overconfidence

Most professional investors struggle to beat the market. They have the tools, computer programs, and a team of people. That doesn’t mean you can’t do better. But is it realistic to expect you’ll always do better?

 

No one wins 100% of the time. Realistically assess your abilities.

 

At year’s end, compare how you’ve done in the market as a whole. Subtract costs of trading activities from profits.

Confirmation And Hindsight Bias

Confirmation:

When you expect something specific to happen, you’re better at contorting vagueness and uncertainty to fit your model.

When researching investments, you’re more likely to have confidence in information that supports your beliefs.

Hindsight Bias:

It occurs when you convince yourself, after the fact, that some past event was predictable, when in fact, it wasn’t.

For example, the dot-com bubble. After the bubble burst, most investors claimed it was inevitable. However, they were still financially devastated by the crash.

Hindsight bias can lead to overconfidence.

Avoiding Confirmation And Hindsight Bias

Be aware of confirmation bias.

Find an impartial second party to assist you.

Mental Accounting

Different Accounts If you lost money before buying an item, you would most likely come up with the cash to try and buy it again. However, you probably wouldn’t spend money to replace an item you’ve already bought and ruined. But isn’t it really the same thing?

Should the Source Matter?

You might use money differently, depending on its source. Tax returns, bonuses, and inheritances might be spent frivolously rather than saved.

How This Influences Investing Many people have odd ways of dividing up their portfolios. They’ll have a separate portfolio of lower risk investments and another portfolio for those that are higher risk.

The rationale behind this is that the higher risk instruments won’t negatively impact the return of the other portfolio. This can lead the investor to put too much money in higher risk investments.

If you divide your money into separate accounts for subjective criteria, you’re using mental accounting.

The criteria might include the source of the income, as well as the intended purpose. For example, income from a second job might be set aside to save for a vacation.

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ink “

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It doesn’t matter where you got it or how you intend to use it.

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“Found” money is the same as earned money.

Pu

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Tog

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erMoney

saved in a jar or in a savings account doesn’t earn interest.

How To Avoid Mental Accounting

A classic study was performed in 1979 by Kahneman and Tversky. During this study, the concept of “prospect theory” was created. The study demonstrated that people will make decisions based on believed gains, rather than losses.

 This means that as people are given two choices with identical outcomes, they’ll choose the option expressed in terms of the gains.

Prospect Theory

You have $1,000 and must choose

one of the following:

A. You have a 50% chance of gaining $1,000

and a 50% chance of

gaining $0.

B. You have a 100% chance of gaining $500.

You have $2,000 and must choose

one of the following:

A. You have a 50% chance of losing $1,000

and 50% chance of losing $0.

B. You have a 100% chance of

losing $500.

Illustrations From Prospect Study

Question 1: Most chose “B”

Question 2: Most chose “A”

It makes no sense to choose “A” for one question and “B” for the other.

The issue is we avoid the perception

of loss. We try to avoid loss more than we try to

seek gains.

Lessons From The Prospect Study

Working

• When you avoid working overtime to avoid paying the taxes even though take-home pay would increase.

Saving

• Maybe you avoid earning interest on bank accounts to avoid paying taxes, although you stand to gain.

Investing

• Investors tend to hold on to losing stocks too long and sell winning stocks too early, both to avoid losses.

Prospect Theory’s Influence: Three Examples

Investors usually take the guaranteed gain, but take on greater risk to avoid a greater loss.

That mindset can be dangerous in the world of investing!

Think of gains as several small occurrences. For example, saving $10 three times is the same as saving $30 at one time.

Think of losses in the opposite way. One $30 loss is just as bad as losing $10 three times.

Prospect Theory’s Influence: Three Examples

Gambler’s fallacy occurs when you believe a random event is influenced by prior events. •Example: If you flip a coin 5 times and get

tails each time, you’ll think the odds are greater that the next flip will be heads even though they’re still 50/50.

Investors will take the money and run after a series of gains. •They think the bottom will likely fall out soon.

•Yet, if they’re losing, they think their luck is about to change and hold on too long.

Avoiding Gambler’s Fallacy•Never assume a trend has to reverse itself soon because it’s been going on for a while.

•Rely on research or actual data to determine what will happen to a stock price or trend.

Gambler’s Fallacy

Defined: The tendency to go along with the group.

Why we do it: The social pressure to conform and the belief that so

many people can’t be wrong.

Avoid herd behavior by

doing your own research.

Also, make intelligent,

rational decisions.

Herd behavior isn’t effective

with investing.

The herd can cause

investments to become

over-valued.

Herd Behavior

Investors commonly overreact to good news.

Thus, good news drives up stock prices more than it should.

Availability bias occurs when investors base their decisions too much on recent information.

Overreaction And Ability Bias

How To Avoid Overreaction And Availability Bias

1. Maintain a reasonable perspective.

2. Avoid getting carried away with the latest and greatest news.

3. Remember that short-term strategies may not bring good results.

4. Research your investments thoroughly.

5. Keep your focus long-term.

“As a bull market continues, almost anything you buy goes

up. It makes you feel that investing

in stocks is very easy and safe andthat you're a financial genius.”

- Ron Chernow

Conclusion

If you’re completely honest with yourself, you’ve probably been guilty of at least one of the irrational behaviors or decision-making processes that we’ve discussed.

But now you’re in a better place. You know what to look for and how to prevent these biases from affecting your investment decisions.

“Investing should be more like

watching paint dry or watching grass grow. If you

want excitement, take $800 and go to Las Vegas.”

- Paul Samuelson