The field of behavioral finance was validated when the 2002 Nobel Memorial Prize in Economics was awarded to psychologist Daniel Kahneman and experimental economist Vernon Smith.

As much as people like to assume absolute rationality and objectivity (as does Modern Portfolio Theory), actual market data shows the opposite. Behavioral finance observes and attempts to explain seemingly irrational behavior and predictable errors made by investors.

An old Wall Street saying goes: Two factors move the market, greed and fear. Greed drives the market upwards, and fear moves the market downwards. CNN actually has a Fear & Greed Index based on the most recent market transactions that serves as an indication on market sentiment.

Intuitively, we all know to buy low and sell high, but we often do the opposite in practice. Before the Dow Jones Industrial Average (DJIA) hit bottom on March 5, 2009, it had dropped around 20% in 2008. In hindsight, it would have been the best time to buy but many investors were still selling. From their perspective, the market had been declining for more than a year and seemed to do so more and more rapidly. Fear was so overwhelming that even into 2012, individual investors were not buying stocks like they used to.

During times of economic turmoil, psychological biases of institutional investors are also exposed. They tend to become too reliant on their elaborate financial models, which lead to overconfidence (an issue that we will discuss later) and consequently excessive risk taking. In the case of the subprime mortgage crisis, many financial institutions would not realize that they had over leveraged themselves until it was too late.

Even the rational side of the brain yields consistent and predictable cognitive errors. Prospect theory, developed by by Daniel Kahneman and Amos Tversky, helps explain why these cognitive errors occur:

  • Firstly, investors use reference points to frame their choices in terms of potential gains/losses.
  • Secondly, investors value the gains/losses with an S-shaped function. The function is concave for gains, convex for losses, and steeper for losses than for gains.
  • Thirdly, investors view each investment as an individual account instead of seeing all their investments as a whole.

Prospect Theory

Another approach to investment psychology is to categorize behavioral biases by source: self-deception, heuristic simplification, and mood (prospect theory is considered a manifestation of heuristic simplification).

Here are 8 sources of irrational investment behavior, as discovered by various behaviorists:

1. Overconfidence

Overconfidence can lead investors to excessive trading and risk taking. There are two aspects of overconfidence: miscalibration and better-than-average effect:

  • Miscalibration means being ignorant of some of the likely outcomes.
  • Better-than-average effect is when people consider themselves better than average, which obviously can’t be true for everyone.

Since people tend to believe that success is attributed to skill and failure is caused by bad luck, small successes in the market may cause investors to become overconfident.

2. Pride and Regret

People are likely to repeat actions that create pride and avoid those that create regret.

Financial economists Hersh Shefrin and Meir Statman found that this behavior causes disposition effect, which is when investors sell winners too early and hold onto losers for too long.

Whether a trade creates pride or regret depends not only on absolute gains/losses, but also the investor’s reference point. If an investor found out that a stock he had recently sold reached a new high, he would be less likely to consider his trade a success, even if he had made money from it. Furthermore, an investor is less likely to repurchase the same stock after experiencing regret from it, as shown in the study conducted by Odean, Barber and Strahilevitz.

3. Risk Perceptions

People’s perceptions of risk change after they win or lose money.

When they win money, they may experience the house-money effect and be more willing to take risks. When they lose money, they may experience the snakebite effect and become less willing to take a risk, or the trying-to-break-even effect and try to reverse losses.

People’s perceptions of risk also change when the asset changes ownership. Endowment effect means that people are less likely to put their inheritance than their year-end bonus into high risk assets, even though they are the same amount of money. The status quo bias means that people may avoid taking action altogether when they feel overwhelmed by investment choices.

It’s not easy to accurately measure an investment’s potential outcomes and probabilities. Unlike a coin toss, the underlying distribution of outcomes of the financial markets is mostly unknown. People are prone to rely on their own limited observation and memory for predicting the future. When people think they know the likely outcomes and probabilities, they expect unusual occurrences to reverse. If not, then they expect unusual occurrences to continue. This is why some investors chase high performances from previous years.

Read How Warren Buffett Thinks About Risk to find out how to properly think about risk so that you can make better investing decisions.

4. Framing

How a question is framed can directly impact how people answer it.

Since people tend to think of an investment as good or bad, they sometimes forget that riskier investments should have higher returns. Daniel Kahneman’s Nobel lecture in Stockholm (for which he received the Bank of Sweden Prize in Economic Sciences) outlined two modes of cognitive reasoning: analytical thinking and intuitive thinking. Intuitive thinking comes so easily and naturally that people are often unaware of it, but it is precisely the type of thinking that investors should avoid.

5. Mental Accounting

Investors have a tendency to view each investment separately. Doing so risks failing to view an investment portfolio as a whole and missing out on opportunities like the tax swap. A tax swap is when an investor sells a losing stock and purchases a similar one, thereby capturing the capital loss from the losing stock to reduce taxes while staying invested.

Another problem with mental accounting is the lack of diversification. Shefrin and Statman’s Behavioral Portfolio Theory (BPT) suggests that investors use mental accounting to match investment goals to asset allocations. Unlike the Modern Portfolio Theory, a behavioral portfolio resembles a pyramid with distinct layers of well defined investment goals. It ignores correlations between the assets and therefore fails to achieve diversification.

6. Heuristic Simplification

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People use mental shortcuts (called heuristics) to quickly organize and process large amounts of information. This process is called heuristic simplification. Two examples are representativeness and familiarity.

  • Representativeness bias causes people to assume good companies are good investments, and believe that past good performances will last into the future.
  • Familiarity bias causes people to stay close to what they are familiar with. They judge familiar stocks with too much optimism and unfamiliar stocks with too much pessimism, leading to lack of diversification and false sense of risk.
The Ultimate List of Cognitive Biases covers every single mental heuristic and cognitive bias that investors should be aware of.

7. Short-Term Focus

As long as we have access to a news outlet, whether it’s the newspaper or the internet, we are constantly flooded with financial news. Our investment activities tend to be influenced by the media and other professional investors. The problem is, people sometimes react too quickly and commit mistakes when they lose sight of the long term.

8. Emotions

Price bubbles are not uncommon and are usually caused by two of the most basic human emotions: greed and fear.

One of the most famous bubbles was the Tulip Mania, which occurred in the Dutch Golden Age. At its peak in 1637, a single tulip bulb sold for more than 10 times the annual income of a skilled craftsman. The bubble burst much more quickly than it was formed. When people started to refuse to honor their transactions, the sentiment turned so quickly that the price plummeted to nothing almost overnight.

What This All Means for Your Investing

Although it’s difficult to defy human nature, we can teach ourselves to avoid some of the above-mentioned errors by following a systematic approach to investing (check out The Ultimate Guide to Value Investing).

After finding an investment style that best suits you, it’s important that you follow through. Use risk management and diversification instead of a goal-based approach, and have a quantitative investment criteria instead of relying on emotions. Memory is often unreliable, so remember to keep a precise and accurate record. Perhaps it helps to write down a few rules of thumb where you can see them, such as: avoid trading too frequently, monthly check on stocks, annual review of portfolio and make necessary adjustments based on risk appetite, etc. To remind yourself to think analytically instead of intuitively, one of the best books to read is Daniel Kahneman’s Thinking, Fast and Slow.

If you want to learn more about heuristics and cognitive biases, check out 6 Cognitive Biases, Heuristics, and Illusions That Daniel Kahneman Thinks Investors Should KnowNine Cognitive Biases You Need to Understand to Master Your Money, and The Ultimate List of Cognitive Biases.

Or even better yet, read through the 3 books listed below.

Finally, don’t forget to pick up your copy of The Ultimate Guide to Value Investing. Your support helps keep Vintage Value Investing ad-free! 🙂

Thinking, Fast and Slow

by Daniel Kahneman

Engaging the reader in a lively conversation about how we think, Kahneman reveals where we can and cannot trust our intuitions and how we can tap into the benefits of slow thinking. He offers practical and enlightening insights into how choices are made in both our business and our personal lives―and how we can use different techniques to guard against the mental glitches that often get us into trouble. Winner of the National Academy of Sciences Best Book Award and the Los Angeles Times Book Prize and selected by The New York Times Book Review as one of the ten best books of 2011, Thinking, Fast and Slow is a classic.

The Undoing Project: A Friendship That Changed Our Minds

by Michael Lewis

How a Nobel Prize–winning theory of the mind altered our perception of reality.

Forty years ago, Israeli psychologists Daniel Kahneman and Amos Tversky wrote a series of breathtakingly original studies undoing our assumptions about the decision-making process. Their papers showed the ways in which the human mind erred, systematically, when forced to make judgments in uncertain situations. Their work created the field of behavioral economics, revolutionized Big Data studies, advanced evidence-based medicine, led to a new approach to government regulation, and made much of Michael Lewis’s own work possible. Kahneman and Tversky are more responsible than anybody for the powerful trend to mistrust human intuition and defer to algorithms.

This story about the workings of the human mind is explored through the personalities of two fascinating individuals so fundamentally different from each other that they seem unlikely friends or colleagues. In the process they may well have changed, for good, mankind’s view of its own mind.

The Intelligent Investor: The Classic Text on Value Investing

by Benjamin Graham

The greatest investment advisor of the twentieth century, Benjamin Graham taught and inspired people worldwide. Graham’s philosophy of “value investing” — which shields investors from substantial error and teaches them to develop long-term strategies — has made The Intelligent Investor the stock market bible ever since its original publication in 1949.

Please see this link for further information on psychology and online therapy: BetterHelp