How Behavior Finance Can Help Investors?

In the last few years there has been many wild swings in the stock market. These wild swings caused financial loss to many investors. Bitcoins is one such example. Price of Bitcoin jumped from a few dollars to more than $1,000 and then it crashed. You can read the post on how bitcoin price jumped above $1000 and then plunged down again. Stock markets are prone to boom and bust cycles. Many investors lose sight of this fact when making their investment decisions. Stock market is an emotional roller coaster. Take a look at the following chart.

Bitcoin Bubble

This is the Bitcoin Bubble chart. It shows the various stages in the formation of a bubble. Bubbles are the same whether it is the stock market, commodity market or the crypto-currency. First you can see, investors crazily drive  price too high forming a bubble. Now a simple prick is needed to burst this bubble. This can come in any form. It can be some rumor that rattles the market like the Chinese government planning to crack hard on bitcoin investors. Whatever, a simple price bursts the bubble and you can see price fell far more rapidly as compared to when it rose. So most of the time you will find market overreacting to the news. People start selling first and then when they have time to reflect and ponder they re-evaluate their overreaction.

Markets are fickle. They tend to overreact towards new information. It has been observed that whenever President Donald Trump speaks , US Dollar plunges. The recent example is that of President Trump firing the FBI Director Comey. US Dollar is under pressure for the last few days and losing value. So you can see how political events effect the financial markets.

Many investors lost their lifetime savings in the stock market crash of 2008. Many had no clue what was happening. Modern finance is build on the concept of an investor who thinks rationally. But do we think rationally when it comes to trading and investing? To find the answer to this simple question whether we think rationally when it comes to making investment decisions, we will have to turn towards the subject of Behavior Finance. Behavior Finance is a subject that tries to explain many things that traditional finance cannot explain.

Failure of Efficient Market Hypothesis

Modern finance makes many simplifying assumptions when it comes to explaining a lot of things that we observe in the markets. For example, we are told that markets are efficient. What this means is that there is no barrier to information exchange and what one investor knows is almost immediately known to all other investors. Information travels very fast and takes away any arbitrage opportunity that might exist between two markets. If the markets are efficient it means that there is no way one can beat it. This has been taught in finance textbooks for many decades. But today this viewpoint is no longer considered to be valid.

Markets are indeed inefficient in the short term at least. There are some market players who have the edge and they use it to beat the market. According to efficient market hypothesis, all publically available information is immediately reflected in asset prices. In other words, assets are priced rationally by the market according to the available public information. Stock price is a random walk. Random walk means we cannot predict the stock price as it is a random walk. For many decades this was the viewpoint taught in standard finance courses. According to this viewpoint, it is almost impossible to beat the market on a consistent basis. But then came persons like Warren Buffet who have been defeating the market on a consistent basis every year. So there are some individuals who have the skills and talent to defeat the market while the majority don’t have those skills.

This is what that is now being taught. We human beings are emotional decision makers. This happens in our daily lives as well as in our investing decisions. Behavior finance is a subject that takes into account human psychology when it tries to explain our behavior as an investor. After all markets are just a refection of our crowd behavior. When irrational fear grips that market, it results in a crash. This is precisely what happened in the stock market crash of 1929. Selling started and no one was willing to buy. The same pattern repeated itself in the stock market crash of 2008. We need to understand the biases that psychologically effect our decisions as investors.

Behavior Finance tries to understand how we as individuals make our investment decisions and how these individual investment decisions then get reflected in the market in the shape of a crowd. As an investor you must have observed that when you suffered a loss you try to take more risk just in order to recoup your loss. This phenomenon is known as Loss Aversion. We always feel more pain when we suffer a loss. So we tend to weigh our losses twice as more as our gains. This compels us to take more risk when we suffer a loss. Did you observe this fact, we tend to stick to a losing stock in the hope that it will turn around in the near future while we tend to sell winning stocks as early as possible so that we don’t lose our profits.

Role Of Biases and Heuristics In Investing

Did you observe that we tend to hold the stocks of our domestic stock market most of the time. US investors hold more than 90% of the US stocks, In the same manner, Japanese investors hold more than 90% of the Japanese stocks. This is despite that fact that most investment newsletters try to point our the diversification benefits of holding international stocks. But we still tend to be biased towards our home markets. This is one form of bias depicted in stock investing. Then there are naïve investors who overdo  when it comes to diversification. They invest in all sorts of stocks thinking that this would diversify the risk. There is another bias that gets reflected in investing. This bias favors good companies with the assumption that there stocks are good investments. This bias tends to overlook the fact that good companies and bad companies are all good investments. Similarly when it comes to choosing an investment funds we tend to favor their past performance.

Understand herd behavior is very important when it comes to understanding market behavior. The important question that comes to mind is why we show herd behavior when it comes to investing. There are 2 reasons. First we as human beings like conformity when it comes to our social behavior. So we tend to do what others are doing in an attempt to conform to a big social group. Secondly we tend to think that a big social group can never be wrong. After all there are many people in a big social group and they cannot all be wrong. So we tend to do what the majority in a social group is doing. For example, you can see this herd behavior when it comes to the world of fashion. Men and women both follow the fashion trends just following what the herd is doing.

Herd behavior is very important when it comes to understanding the markets. One form of herding works by the word of mouth. We tend to trust our family members and friends. If they are investing in some asset , we also tend to invest in that asset. After that media also plays an important role in enforcing this herd behavior. However herd mentality most of the time can be costly.

Excessive Trading and Overconfidence

We most of the time tend to overestimate our talent. This results in overconfidence in estimating the risk involved in investing in a particular asset. Investor overconfidence is a major cause of market overreaction and high volatility. Overconfidence is an overvalued sense of one’s cognitive abilities in analyzing the market. Numerous studies indicate that investors are overconfident in their investing abilities. Overconfidence in tech stocks led many investors to lose heavily during the Dot Com bubble. Overconfidence can be detrimental to you as an investor. Researchers have developed diagnostic tests for overconfidence. You will be handed over a questionnaire that will determine your overconfidence bias.

Can Behavior Finance Solve Stock Market Puzzles?

Behavior finance can explains stock market puzzles like the January Effect and the Winners Curse. January Effect takes place when stocks do well during January at the start of each new year. This has something to do with the tax benefits that small investors get by selling losing stocks in December to lock in tax benefits. But January Effect has also been observed when there are no tax benefits.

The phenomena of winners curse is particularly important for those investors who love to invest in IPOs. Winner curse takes place when you bid more than the value of the asset. In the case of an IPO, it has been observed most of the time that investors happily buy overvalued stocks. This particularly happened in the case of Facebook IPO. It also happened recently in Snapchat IPO. Winners curse is a reminder that investors are not rational when it comes to investing decisions.

Let’s consider a few famous stock market bubbles. One such bubble was the Tulipmania. South Sea Bubble is another example of a stock market bubble. Stock market crash of 1929 was also the result of a bubble that burst and bankrupted many individual investors. Recent example of the bubble is also illustrative. Housing market bubble caused other markets like the mortgage securities market to crash that eventually led many banks to fail which eventually resulted in the stock market crash of 2008. I have developed a course on Behavior Finance for Investors in which I discuss these topics in great detail. You might like to take a look at my course Behavior Finance for Investors.