Behavioral finance can be a bit of a turn-off for some private investors, but for those who avoid it, it means missing a trick that can reap huge rewards. A basic awareness of behavioral finance can certainly help you keep your head in extreme markets – whether those markets are buoyant or depressed, calm or volatile. In short, it can help us break wealth-destroying patterns of behavior – and achieve the opposite result.

But let’s start with a brief look at how and why this is theoretically possible.

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The Efficient Market Hypothesis

According to the “efficient market hypothesis” (EMH), stock markets are efficient. Because investors all have the same information and analyse that data in the same ways, their forecasts should be identical or similar – or so the hypothesis goes. Therefore, the theory has it, it isn’t possible to produce consistently market-beating returns as market prices reflect all known information at any given time. What’s more, it isn’t possible to try and time the market if EMH is valid.  So the only way investors can generate market-beating returns is through buying into riskier investments.

But in reality, many investors consistently beat the market for very long periods. The most famous example of all, perhaps, is Warren Buffett’s Berkshire Hathaway investment group. A $10k investment in the stock in 1965 would now be worth over $88m - while the same investment in the S&P 500 would be worth $1.3 million. There are many other examples of investors who have beaten the indices over long periods including Peter Lynch, Anthony Bolton and others.

So given that it clearly is possible to beat the market, and consistently so, how do we do it?

Behavioral Finance

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Behavioral Finance

This is where behavioral finance comes in; this is a psychology-based approach which seeks to explain stock market movements by looking into the emotions and behavior of investors. Get your basic psychology right and put tools in place to control it, and your returns will be better than average.

As investors, we tend to repeat the same mistakes. A knowledge of how and why we’re making those mistakes through some understanding of behavioral finance will allow us to prevent them in the future.

Behavioral Finance

Image source: Anirud Sethi Report

One of the leading academics in this area is Canadian-born Economist Hersh Shefrin. Shefrin has written many papers relating to behavioral finance which are of interest to serious investors, funds and academics. But even a basic understanding of the gist of the work can help private investors improve their decision making.

Shefrin points out that for most private investors, investments play an enormous role in determining current and future wealth – but also that designing and managing a portfolio also represents a set of complex financial decisions which require a huge cognitive load.

He also talks of heuristic-driven bias; the notion that investors have poor insight into statistics and probabilities and instead rely on things like intuition, past experience, trial and error. Shefrin also says investors place too much reliance on “stereotypes”. For instance, we tend to expend a company that has announced good news to “inevitably” do so again and so on.

Putting these two factors together is a worrying prospect for the individual investor, or at least, it should be!

This overreliance on non-objective, non-statistical data as well as a biased approach to stats make investors vulnerable to errors and poor decision making. These heuristic biases include what are described as “overconfidence”, “anchoring and adjustment”, “frame dependence”, “availability”, “representativeness” and “aversion to ambiguity”.  There are many other types of cognitive bias that help sway us from an otherwise objective viewpoint.

So let’s get down to it, have a look at each area – then consider ways of avoiding these traps…

  1. Overconfidence

Most experienced investors will be familiar with the pitfalls of overconfidence.  According to Shefrin, "There are two main implications of investor overconfidence. The first is that investors take bad bets because they fail to realize that they are at an informational disadvantage. The second is that they trade more frequently than is prudent, which leads to excessive trading volume."

How many of us aren’t guilty of placing too much faith in our forecasting abilities? Overconfidence implies that individuals overvalue their knowledge or abilities. Other academics have also postulated that overconfident investors won’t learn from their mistakes as they don’t see it as a bias that affects their decision making. They’re blind to their own failings in other words – and, therefore, likely to repeat their mistakes.

Overconfidence may be a factor in today’s market. Anyone new to the investing game may think they’re a genius with the FTSE 100 at or near record levels following a 25% post-Brexit rally. But as investment great Ben Graham said, “the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions."

And as the aforementioned Anthony Bolton says; “When investments go well, you mustn’t get too full of yourself and believe everything you touch will turn to gold. It won’t.”

  1. Anchoring and adjustment

Anchoring and adjustment is a common psychological weakness in different walks of life. The theory holds that we place too much on the initial piece of information we discover – the "anchor".

Once we’ve “dropped anchor”, subsequent judgments are made by making adjustments to the anchor. But our bias is in interpreting subsequent information around that anchor.

Of course, retailers and salesmen have been using anchoring to good effect for donkey’s years. This product “should” be X price normally, but is currently available at… etc.

As investors, we sometimes tend to “overanchor” our initial assessments, without reassessing that information and without giving new information sufficient attention. In other words, we want to be proved right, so we are too stuck in our initial analysis. This may be reflected in the price of a share, for example. If your initial analysis held that BT Group (BT.A) shares were good value 18 months ago at £5, you may think that c.£3 is cheap without giving sufficient weight to the investigation into BT's Italian business, for example.

  1. Frame dependence

“Frame dependence” holds that investors’ risk tolerances change with the overall direction of the market. Therefore, investors are overly cautious in a falling market, and too confident when things are going well. This helps explain markets’ tendencies to overshoot and runs completely contrary to true contrarianism.

The “Sage of Omaha” Warren Buffett sums this up famously urging us to do the opposite, saying: “Be fearful when others are greedy and greedy when others are fearful,” which sounds rather a lot like timing the market, by the way.

Of course, many investors do the exact opposite:

Behavioral Finance

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We may well be in such a situation now. The FTSE chart is surfing a wave of optimism based on positive economic data – including better than expected employment and manufacturing data from the U.S. But there are eye-watering P/Es to match. The average P/E of the UK’s largest companies is now around 35. The historical average is 15. This may be a blunt financial measurement, but consider that in 1999 and early 2000, the ratio reached 30 – whilst in 2008-9 at the peak of the financial crisis, it was well below ten.

  1. Availability bias

Availability bias concerns investors’ tendency to focus too much on information that is often mentioned and readily available without giving sufficient weight to other factors which may be less readily available/more hidden, or which just aren’t deemed as newsworthy or important.

Behavioral Finance

Image source: James Clear

Any investors reading some of the more “bullish” bulletin boards on individual stocks will be very familiar with this kind of bias. It’s a similar bias to only listening to one side of the bear-bull argument, when there are two sides to any market by definition.

  1. Representativeness

Representativeness bias is defined as “the degree to which an event is similar in characteristics to its parent population, and reflects the salient features of the process by which it is generated". This creeps in when we give too much weight to a single or recent event – and when we base future extrapolations on expectations based upon past experiences. Often, a trend is already well-established, but we still give too much weight to that trend.

Investors may, for example, forecast future earnings based on the rapid growth of recent years, and unrealistically presume this will continue, believing only the most optimistic forecasts. All this leads to overpricing. In such situations, any actual blip in earnings can send share prices into freefall.

Representativeness is sometimes used as a criticism for chartists' techniques which are based on the recent performance of a chart in determining future direction of that chart.

"We shall overcome" - Beating your own bias

So how does the ordinary private investor try to overcome these biases?

A word of warning first; there are various tactics, but perhaps the biggest factor to consider if you’re working alone is how you’ll adhere in the future to the resolutions you set yourself today. Self-discipline and adherence to the rules you yourself set is the biggest single challenge here.

As the aforementioned Anthony Bolton says; “if you are very emotional you may not make a good investor as you will be too influenced by the prevailing investment climate.” This is our biggest hurdle; overcoming emotion in both the good times and the bad.

Quantitative criteria

Overall, it’s important to develop your own quantitative criteria to make your decisions as objectively as possible. Looking at profitability, growth, liquidity, leverage, P/E ratios, yield, price-to-book value and other factors for investment, as well as giving each area an appropriate weighting can help you arrive at decisions objectively without being swayed by too much qualitative judgement. Of course, there’s a big place for qual, but make sure the quant is in place first. Otherwise, reject the investment (long or short). There will always be further opportunities.

This approach also necessitates acceptance in letting a few get away; this is part and parcel of the successful investor’s lot. Star Trek’s Mr Spock’s objective approach, keeping emotion out of your decision making, can help avoid investing traps. If the numbers don’t stack up, try not to make the investment fit – it won’t, because it’s illogical.

Checklist

Similarly, having a checklist to consult before you hit the buy/sell button is good self-discipline. Few investments will meet all your own criteria, but most should meet most – and your checklist will help iron-out many of the above biases.

"Phone a friend"

If there are fellow investors whose opinion you value, then discussing all trades beforehand and trying to get “clearance” can help enormously in cooling your ardor and pointing out the counter argument.

Making such “clearance” a precondition can help preserve wealth.

Contrarianism

Let’s get back to Buffett. Trying to be a little more bearish than usual in bull markets and vice versa in predicting earnings and future prospects can help overcome irrational pessimism or irrational exuberance. A similar tactic lies in setting strict automatic buy or sell limits based on your microanalysis. Then, when the macro effects of what Ben Graham called “Mr Market” take that investment irrationally high or low, you’ve lost your objectivity – your automatic trade will do the hard part for you.

David Dreman's “Contrarian Investment Strategies“ is the definitive book on this subject.

Warren Buffett suggests we should invest in equities as if we were buying the whole company. He also said we should invest as if the market will be closed for the next decade. Following this kind of thinking helps overcome cognitive bias and helps focus our minds on likely future profits, assets, debt, sales and cashflow and so on.

Avoid bubbles

Similarly, by concentrating on company specific information and being realistic about likely future earnings and balance sheet strength, you should be able to tell when an individual company’s valuation is too high or too low.

The same is true of indices which generally revert to mean. You’ll probably miss some of the absolute crazy peaks, but you’ll sleep better at night.

Stop-losses

Stop-losses don’t always work 100%, but they are helpful in helping prevent you from selling too soon, thereby maximizing the potential of those crazy peaks.

Find what works

Finding proven investment strategies and following their advice can be enormously helpful (unless the provider is trying to sell that advice). “What Has Worked in Investing” (by Tweedy, Browne)  is a good example.

Overall

Putting in place strategies in calm times to overcome our innate weakness in more turbulent times is desirable. The more watertight those strategies can be, the more successful we are likely to be as investors. Self-discipline (and the strategies to ensure self-discipline) is vital.

We all make investing mistakes. Accepting them, learning from them and trying to prevent their recurrence is what this is all about – and a self-awareness through some understanding of behavioral finance can help private investors break wealth-destroying patterns of their own behavior.

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