What is behavioral finance
Behavioral finance is relatively a new field in the academic world of Finance. In a nutshell, it’s a combination of psychology and conventional economics. Research in this new field have contributed greatly in understanding retail investors’ behavior and its impact on market efficiency. If you are a retail investor, it’s probably the theory you should most understand and apply before making investments decisions. The good news is there is no complicated formulas here! Just common sense and principles we tend to overlook.
How emotions ruined my first investments’ plan
My initial plan
I remember the first time I had 5,000 $ to invest. I started by putting forward a plan to diversify my investments. I chose 50% fixed income and 40% equities. And, I made a decision to put a 10% of my investments in risky assets. To find this risky asset, I used google search and started randomly reading articles.
Poor research lead to poor decisions
Then, the idea to invest in a Natural Gas ETF came about. After just half an hour of research, Natural gas seemed like the best next move I could ever make! Why? It took me just a look at one graph describing the relationship between Oil and Natural Gas since the 1930’s. According to the author of the graph, the ratio was always almost 1/10. He was arguing you can’t have oil trading at 100$ a barrel (at that time) and Natural Gaz lingering below 3$. Natural Gaz was undervalued and should be at 10$. It just didn’t make sense according to him. He concluded every investor should rush and invest in Natural Gaz. Boy, the article was intentionally deceiving and omitted serval other factors that determine Natural Gaz price. For me, however, at that time, it made all the sense of the world.
Greed
I was checking my investments everyday. Most of my portfolio wasn’t moving much with the exception of the Natural Gas ETF that I have picked which was soaring by 5% on a daily basis. I have to insist ‘I have picked’. Without knowing I became attached to this single investment decision. It kind of made me proud!
Soon later, I decided to change my plans. I invested 80% of the 5,000 $ in the Natural Gas ETF. Why? Just out of greed. I felt it’s the right thing to do! After all, the past weeks have showed me I was a genius!
3 weeks later, after my ETF had gone up 30%, it started dropping rather quickly. Did I sell? Off course, No way. I was proud of my move. This sudden dip wouldn’t scare me. Did I research why Natural Gaz was losing ground? Obviously No. I was confident that my investment will pick up!
Refusal to admit my mistake
A week later, I realized I lost 2,000 $ just because of that ETF. What shocked me is I was still convinced it would go up. I had hope in my heart and it gave me confidence to carry on. I started watching BNN and reading every article that talks about Natural Gas to get some information that can back me up in my denial.
2 months later, I was watching a guest at a BNN program. The guest was asked about Natural Gaz prospects and how many investors believe it would go up! The guest seemed really frustrated by the question and the premise of Natural Gaz going up. He answered there is no way. There is ample supply because of a new technology called fracking. This technology allowed supply to go to levels unseen before, while the demand did not change at all. He concluded there is basically not a single evidence pointing otherwise.
2 seconds later, I had sold my Natural Gas ETF at a loss of over 65% of the amount invested. It really served as a lesson. And, it was a relief getting over this investment ☹
How understanding behavioral finance would have helped me?
Behavioural finance help us understand our bias. Researchers identified four of those:
Overconfidence
As retail investors, we are all overconfident. It’s by far the most common bias! After all, a retail investor relies on himself to make an investment decision. It’s hard to question our own research and be the judge on our own analysis.
My advice is to change our attitude and develop a disciplined methodology.
- Our research should be only from a trusted source! We should give more credit to information from serious sources and less to unverified sources;
- We should make sure to cover the topic we are investigating from all sides. If I am contemplating investing in a commodity for instance, I need to understand the supply of it and the demand. I should also look at what could shake up the status quo (new technologies or any major structural change in the short term).
Reducing regret
We all have done this. We get attached to a lousy investment. We can’t admit it was a mistake. As my former university professor described this, it’s like refusing to concede that your girlfriend dumped you, so you spend months next to the phone awaiting her phone call.
As humans, we try to avoid the feeling of regret. And this behavior can be costly in the world of investing. Let’s say you picked a value stock. You did your research and was convinced it’s the right move. Soon later, you realize this company is struggling and can’t deliver the outcome you are hoping. Moreover, the price of its shares start falling. Instead, of re-assessing your research and admitting it was not a good choice, you keep hoping it will comeback. Your hope is solely nourished by the fact that you can’t admit the reality. Consequently, instead of accepting a small loss and turning the page, you stay long and lose more money.
Limited Attention Span
We live in the age where distraction is everywhere. Media and social networks magnify news surrounding certain stocks or investment opportunities and thus condition us to act on these information bubbles. Psychologist Herbet Simon calls this ‘Bounded rationality’. As humans we want to reach decisions based on the limited knowledge we accumulate. Most of this knowledge is from specific pieces of news that social networks and media choose to emphasize. Ton of other information goes absolutely under the radar.
The media covers only a small portion of the equity market. We have to dig deeper in our research to find real valuable piece of information. This extra research will help find businesses full of potential and no one is talking about yet! To overcome this bias, we definitely need to diversify our source of information so we don’t limit ourselves to what the main stream media is covering. Finally, don’t let the media noise impact your decisions!
Chasing Trends
Humans love trends! In fact, research show that 39% of all new money committed to mutual funds went into the 10% of funds with the best performance the prior year. We tend to believe pattern will repeat themselves which is not true. In fact, we will end up buying the highs and sometime we enter right when the stock starts retreating.
If a stock has been going up steadily. It means simply that investors identified its potential a long time ago before you noticed. While they reap the fruits of their investments, you are embarking too late to see any profits coming your way.
As Warren Buffet mentioned in his approach: buy when others are fearful and sell when they’re confident.
Conclusion:
We are all guilty to a certain degree for letting these biases decide our financial moves. The best strategy is to have principles in place:
- The investment plan where you have determined the allocation that best fit your personality and investments’ objective is a long term plan. You have to stick it. Do not replace your long term plan, with short term trading strategies. Research studies have all shown that retail investors who frequently trade have a much lower performance than buy and hold retail investors who trade far less;
- Analyze your investments choices with objectivity. Do not act on feelings or media noise!
- Base your decisions mainly on information from valuable sources.
Great Books on investing on Amazon!
The Intelligent Investor: The Definitive Book on Value Investing The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money Financial Freedom: My Only Hope: The bestselling guide to mastering the ‘game of money’