Introduction to Behavioral Finance
According to conventional financial theory, the world and its participants are, for the most part, rational “wealth maximizers.” However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways.
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.
By the end of this tutorial, we hope that you will have a better understanding of some of the anomalies (e.g., irregularities) that conventional financial theories have failed to explain. In addition, we hope you gain insight into some of the underlying reasons and biases that cause some people to behave irrationally (and often against their best interests). Hopefully, this newfound knowledge will help you when it comes to making financial decisions.
Meaning of Trading Psychology
Trading psychology refers to the emotions and state of mind, which help determine success or failure in securities trading. Trading psychology reflects different aspects of the character and behaviour of a person which influence their trading acts. Trading psychology may be as critical in assessing trading performance as other qualities such as awareness, experience, and ability.
Risk-taking and discipline are two of the most important aspects of trading psychology because the execution of those aspects by a trader is critical to the success of its trading strategy. Although fear and greed are the two most widely recognized emotions associated with the psychology of trading, hope and remorse are other emotions that influence trading actions.
Why is Trading Psychology Important?
Trading psychology is important for technical analysts to drive their trading decisions by relying on charting techniques. Security charting can provide a large array of perspectives on the movement of a defence. Although technical analysis and charting techniques can help identify patterns for buying and selling opportunities, market movements need understanding and intuition, which is derived from the trading psychology of an investor.
Throughout technical charting, there are several occasions where a trader will rely not only on the experience of the chart but also on their understanding of the protection they are observing and their intuition of how broader factors influence the market. Traders who focus on comprehensive security price influences, discipline, and confidence will express balanced trading psychology. Such an attitude contributes to profit and success.
Psychology and Investing
Successful investing is hard, but it doesn’t require genius. In fact, Warren Buffett once quipped, “Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” As much as anything else, successful investing requires something perhaps even more rare: the ability to identify and overcome one’s own psychological weaknesses.
Over the past 20 years, psychology has permeated our culture in many ways. More recently its influences have taken hold in the field of behavioral finance, spawning an array of academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests.
Experts in the field of behavioral finance have a lot to offer in terms of understanding psychology and the behaviors of investors, particularly the mistakes that they make. Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behavior might move the market.
In this lesson we’d prefer to focus on how the insights from the field of behavioral finance can benefit individual investors. Primarily, we’re interested in how we can learn to spot and correct investing mistakes in order to yield greater profits.
Some insights behavioral finance has to offer read like common sense, but with more syllables.
Overconfidence refers to our boundless ability as human beings to think that we’re smarter or more capable than we really are. It’s what leads 82% of people to say that they are in the top 30% of safe drivers, for example. Moreover, when people say that they’re 90% sure of something, studies show that they’re right only about 70% of the time. Such optimism isn’t always bad. Certainly we’d have a difficult time dealing with life’s many setbacks if we were die-hard pessimists.
However, overconfidence hurts us as investors when we believe that we’re better able to spot the next Microsoft (MSFT) than another investor is. Odds are, we’re not. (Nothing personal.)
Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. Trading rapidly costs plenty, and rarely rewards the effort. We’ll repeat yet again that trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns. These frictional costs will always drag returns down.
One of the things that drive rapid trading, in addition to overconfidence in our abilities, is the illusion of control. Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.
Another danger that overconfident behavior might lead to is selective memory. Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing. In terms of investments, we certainly don’t want to remember those stock calls that we missed (had I only bought Apple (AAPL) in 2005) much less those that proved to be mistakes that ended in losses.
The more confident we are, the more such memories threaten our self-image. How can we be such good investors if we made those mistakes in the past? Instead of remembering the past accurately, in fact, we will remember it selectively so that it suits our needs and preserves our self-image.
Incorporating information in this way is a form of correcting for cognitive dissonance, a well-known theory in psychology. Cognitive dissonance posits that we are uncomfortable holding two seemingly disparate ideas, opinions, beliefs, attitudes, or in this case, behaviors, at once, and our psyche will somehow need to correct for this.
Correcting for a poor investment choice of the past, particularly if we see ourselves as skilled traders now, warrants selectively adjusting our memory of that poor investment choice. “Perhaps it really wasn’t such a bad decision selling that stock?” Or, “Perhaps we didn’t lose as much money as we thought?” Over time our memory of the event will likely not be accurate but will be well integrated into a whole picture of how we need to see ourselves.
Another type of selective memory is representativeness, which is a mental shortcut that causes us to give too much weight to recent evidence–such as short-term performance numbers–and too little weight to the evidence from the more distant past. As a result, we’ll give too little weight to the real odds of an event happening.
Researchers have also observed a behavior that could be considered the opposite of overconfidence. Self-handicapping bias occurs when we try to explain any possible future poor performance with a reason that may or may not be true.
An example of self-handicapping is when we say we’re not feeling good prior to a presentation, so if the presentation doesn’t go well, we’ll have an explanation. Or it’s when we confess to our ankle being sore just before running on the field for a big game. If we don’t quite play well, maybe it’s because our ankle was hurting.
As investors, we may also succumb to self-handicapping, perhaps by admitting that we didn’t spend as much time researching a stock as we normally had done in the past, just in case the investment doesn’t turn out quite as well as expected. Both overconfidence and self-handicapping behaviors are common among investors, but they aren’t the only negative tendencies that can impact our overall investing success.
It’s no secret, for example, that many investors will focus obsessively on one investment that’s losing money, even if the rest of their portfolio is in the black. This behavior is called loss aversion.
Investors have been shown to be more likely to sell winning stocks in an effort to “take some profits,” while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, “More money has probably been lost by investors holding a stock they really did not want until they could ‘at least come out even’ than from any other single reason.”
Regret also comes into play with loss aversion. It may lead us to be unable to distinguish between a bad decision and a bad outcome. We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons. In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more.
It also doesn’t help that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It’s this unwillingness to accept the pain early that might cause us to “ride losers too long” in the vain hope that they’ll turn around and won’t make us face the consequences of our decisions.
An anchoring bias is a mental flaw that impacts the way a person derives the price of anything. For example, if a person goes to a shopping mall and they see that the price of a particular product to be $100 and then after a 50% discount they have to pay $50, they may be more inclined to buy the product. This is because the discount makes the product appear cheaper and increases the value of the deal in the mind of the buyer. On the other hand, if the seller directly offered the product at a $50 price, then the seller might find the price to be expensive.
The anchoring bias is based on the fact that the first or initial information about the price of a product creates an anchor in our minds. We view all the subsequent information in the light of that anchor. This is particularly important in financial markets wherein people have to view prices and make buy and sell decisions every day. Companies all over the world use anchoring bias to sell more products. This is the reason that e-commerce portals all over the world will write a higher price, then show and discount before they finally mention the selling price.
Confirmation bias is our tendency to cherry-pick information that confirms our existing beliefs or ideas. Confirmation bias explains why two people with opposing views on a topic can see the same evidence and come away feeling validated by it. This cognitive bias is most pronounced in the case of ingrained, ideological, or emotionally charged views.
Failing to interpret information in an unbiased way can lead to serious misjudgments. By understanding this, we can learn to identify it in ourselves and others. We can be cautious of data that seems to immediately support our views.
Another risk that stems from both overconfidence and anchoring involves how we look at information. Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favorably.
For instance, if we’ve had luck owning Honda (HMC) cars, we will likely be more inclined to believe information that supports our own good experience owning them, rather than information to the contrary. If we’ve purchased a mutual fund concentrated in health-care stocks, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.
Hindsight bias also plays off of overconfidence and anchoring behavior. This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome. Our judgment of a previous decision becomes biased to accommodate the new information. For example, knowing the outcome of a stock’s performance, we may adjust our reasoning for purchasing it in the first place. This type of “knowledge updating” can keep us from viewing past decisions as objectively as we should.
The mental accounting concept was introduced by Richard Thaler in a paper titled “Mental Accounting Matters,” which was published in the Journal of Behavioral Decision Making. Thaler noted that people place the value of money differently, and it exposes them to irrational decision-making. In simple terms, the concept states that individuals classify money differently based on subjective criteria, and it often leads people to make irrational spending and financially counterproductive investment decisions.
The concept suggests that people do not treat money as fungible – i.e., mutually interchangeable – and instead, link their spending to particular budgets. For example, if an individual is paid an end-year bonus of $1,000 for exemplary performance, they may feel that the bonus allows them to spend money on extravagant items, such as meals, lavish vacations, and other expenses that they would never justify spending regular income on. The concept holds that people are more likely to be impulsive with unexpected money because such money was not factored in their financial plan.
We often talk about seeing circumstances as a glass half full or half empty. Seeing reality as a “glass half full” means you’re viewing it from the frame of an optimist. Seeing reality as a “glass half empty” means you’re coming from a negative frame of reality.
At its purest, framing is the way that you view the world. This is called cognitive bias, which essentially means that you react differently to information based on whether it is presented to you in a positive or negative way. No matter which way you see things, it directly impacts the decisions that you make.
The framing effect is when someone reacts to a choice or concept based on how it is framed or presented to them. Let’s say that someone wants to perform a surgery on you, and they say that you have a 90 percent chance of survival. That sounds pretty good, right? If it was framed differently, by saying you have a 10 percent chance of death, your reaction would probably be different. This is because of cognitive bias. We are likely to feel good about something if it is presented to us in a positive way or in a way that can benefit us. But we may start to worry if the same thing is presented to us with a negative frame. A 90 percent survival rate and a 10 percent chance of death are the same things, but our mind tends to dislike something if it is presented negatively. Understanding the framing effect can help you discern how people are communicating with you and why you may be reacting in a certain way.
In 1979, studies confirmed the legitimacy of the framing effect. Two people, Amos Tversky and Daniel Kahnemann, were trying to show that framing can influence the choices we make. In advertising a product, the product needs to be presented in a positive way. If someone is selling a product for you that is made with 80 percent natural ingredients, it’s worth mentioning that it’s made almost entirely with all-natural ingredients instead of saying that 20 percent is artificial. This study gave birth to the concept ofprospect theory. The idea of prospect theory is that people look at decisions by measuring gains and losses. Someone is going to avoid your product if the “loss” is presented and vice versa. If someone is going to gain anything out of it, they will more than likely buy your product. If you’re selling a product that kills 99 percent of germs, framing it so that it says that 1 percent of germs will survive may turn people off.
There are thousands and thousands of stocks out there. Investors cannot know them all. In fact, it’s a major endeavor to really know even a few of them. But people are bombarded with stock ideas from brokers, television, magazines, Web sites, and other places. Inevitably, some decide that the latest idea they’ve heard is a better idea than a stock they own (preferably one that’s up, at least), and they make a trade.
Unfortunately, in many cases the stock has come to the public’s attention because of its strong previous performance, not because of an improvement in the underlying business. Following a stock tip, under the assumption that others have more information, is a form of herding behavior.
This is not to say that investors should necessarily hold whatever investments they currently own. Some stocks should be sold, whether because the underlying businesses have declined or their stock prices simply exceed their intrinsic value. But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons. We can all be much better investors when we learn to select stocks carefully and for the right reasons, and then actively block out the noise. Any temporary comfort derived from investing with the crowd or following a market guru can lead to fading performance or inappropriate investments for your particular goals.
18 trading rules by Martin Pring to beat market & fetch big returns
Famous author Martin Pring says there is no easy route to get rich in the financial market as the task of ‘beating ourselves’ which means mastering emotions, thinking independently as well as not being swayed by those around us is extremely difficult.
According to Pring, success based on an emotional response to market conditions is a result of chance, and it does not help investors attain consistent results as objectivity is not easy to achieve because all investors are subject to fear.
- Rule No. 1: When in doubt, stay out.
- Rule No 2: Never Invest or Trade Based on Hope
- Rule No 3: Act on Your Own Judgment or Else Absolutely and Entirely on the Judgment of Others
- Rule No 4: Buy Low (into weakness), Sell High (into strength)
- Rule No 5: Don’t Overtrade
- Rule No 6: After a Successful and Profitable Trading Campaign, Take a Trading Vacation
- Rule No 7: Take a Periodic Mental Inventory to Check How You Are Doing
- Rule No 8: Constantly Analyze Your Mistakes
- Rule No 9: Don’t Jump the Gun
- Rule No 10: Don’t Try to Call Every Market Turn
- Rule No 11: Never Enter into a Position Without First Establishing a Reward to Risk
- Rule No 12: Cut Losses Short, Let Profits Run
- Rule No 13: Place Numerous Bets on Low Risk Ideas
- Rule No 14: Look Down (at the risk potential) not Up (before your reward potential)
- Rule No 15: Never Trade or Invest More Than you Can Reasonably Afford
- Rule No 16: Don’t Fight the Trend
- Rule No 17: Whenever Possible Trade Liquid Markets
- Rule No 18: If You are Going to Place Stop, Put it in a Logical, Not Convenient Place