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Behavioral Finance Theory

Written By Brian Hicks

Posted August 6, 2009

Damn the fundamentals. . . full speed ahead!

That’s the mojo of the bulls these days, as the greatest rally in history keeps pushing the markets higher.

But just because the markets have turned green again doesn’t necessarily mean that the storm has passed, as I discussed last week.

That’s because whether the bulls want to admit it or not, "irrational exuberance" is alive and well these days, since the S&P 500 is now trading at nosebleed heights — with a price to earnings ratio of 65.32.

Of course, "irrational exuberance" is a phrase made famous by our old pal, Alan Greenspan. The down-beaten maestro uttered it a full four years before the dot-com bubble burst, costing investors $5 trillion in the process.

Even still, those two famous words turned out to be much more than a mere warning that stocks were overpriced. They also helped to turn the idea of the efficient market hypothesis right on its head.

A rational market?

Not hardly, according to Greenspan. And while I’m not exactly a member of the Alan Greenspan Fan Club, on this score he couldn’t have been more right.

Behavioral Finance and Investing

After all, the tenets of behavioral finance and investing go hand in hand, since every market trades in some measure on the human condition otherwise known as emotion.

Because as we have now learned in dealing with two massive bubbles in only ten years — first in tech and then in housing — the markets are not rational at all. . . at least not in the short run.

As the concept of behavioral finance implies, there is always a ghost in the machine. And because of this ghost, things aren’t always as they appear to be — especially when it comes to the stock market. . .

The reason for this, of course, is simple: the markets are made up of people. That makes them messy at times and unpredictable, since market players sometimes behave irrationally.

But by understanding how and where your reasoning can go astray, you can help build up your portfolio by simply choosing to limit your losses on far more of those "irrational" losers. After all, when you ignore the fundamentals, you do so at your own peril.

The key here, though, is in learning to recognize how the cognitive biases related to behavioral finance have handicapped your investing in the first place.

I call these biases, "Eleven Reasons Why What You Think is Probably Wrong." Learning to recognize these reasons can save you a ton of heartache. . . but only if you’re honest with yourself.

The eleven emotional hurdles that could be killing your portfolio:

  1. The Bandwagon Effect: This is the one that causes the most pain in a bubble. It’s the idea that it’s okay to follow the herd because so many other people believe in it. It’s irrational because it places faith in the safety of numbers, while completely disregarding the fundamentals. Without it, a bubble is impossible.
  2. Loss Aversion: People tend to have a strong preference for avoiding losses over acquiring gains. It’s the fear that puts them on the sidelines to stay.
  3. Disposition Effect: This is the tendency for investors to lock in gains and ride out losses. It prompts the sale of shares that are rising, while it also keeps investors tied to losers for far too long. It’s closely tied to loss aversion, since it’s the fear of loss that dominates the thinking.
  4. Outcome Bias: Judging a decision by its outcome, rather than the quality of the decision at the time that it was made. This is what makes investors completely disregard a proper decision if it turns out to be a loss.
  5. Sunken Costs Effect: Treating money that has already been spent as more valuable than money that may be spent in the future. It’s what helps to build up losses because the investor believes that by selling at a loss, he is wasting money. That same money could be put to use elsewhere.
  6. Recency Bias: Weighting recent data more heavily than earlier experiences. It’s what freezes investors, especially after a series of losses, even though there may be a much longer string of successes in the past.
  7. Anchoring: This is the tendency for people to rely too heavily on readily available information when making a decision. Investors often base their decisions on information that may be faulty.
  8. Belief in the Law of Small Numbers: This is when investors base their conclusions on a slice of data that is too small. It’s the equivalent of making mountains out of molehills, and it blurs reality.
  9. Endowment Effect: People tend to value something more once they own it. As in housing, people tend to overvalue what belongs to them. Of course, this only blinds to them to the real value.
  10. Disconfirmation Bias: This makes people critical of information which contradicts their beliefs, while uncritically accepting information that is in line with them. In short: it’s a trap whereby people believe what they want to believe.
  11. Post-Purchase Rationalization: This is when investors persuade themselves through rational argument that a purchase was a good value. Of course, if a decision needs to be rationalized after the fact. . . it was probably wrong.

Individually, all of these biases are dangerous. And taken together, they are the stuff that bubbles are made of. Guarding yourself  against them in the future may be the one of the best investment decisions you’ll ever make.

Because Mr. Greenspan nailed it when he said that markets were irrational. Fundamentals really do matter.

Your bargain hunting analyst,

steve sig


Steve Christ, Investment Director

The Wealth Advisory

PS. When it comes to fundamentals, the worst sector on the board these days has to be commercial real estate. In fact, it has gotten so bad lately that industry leaders have estimated that 200,000 businesses and ten percent of the nation’s shopping malls will close their doors over the next year. To learn more about this brewing disaster, click here.