A trader who wants to be smarter than the market has already lost – that is a tenet of Behavioral Finance. A trader who is aware of his irrational behavior, however, has a chance to succeed. An introduction through the world of human weaknesses and the lessons that investors should draw from it.
“How could I be so stupid?”
If you haven’t asked yourself this question before, you are no real trader. People make countless decisions every day. Some are important, some are not. Making a wrong decision can cost thousands or millions of dollars. Why do people make wrong decisions? And how can a trader protect himself from backing on the wrong horse? Here an explanation from a psychological perspective:
When it comes money, economists often portray an investor as homo economicus who always make financial decisions using a rational judgment. Psychologists, however, have a slightly different view. Numerous experimental studies have shown that decision makers have considerable difficulties to evaluate information immediately. Especially in financial surroundings, humans are liable to emotions and inherent behaviors. According to financial guru André Kostolany;
“stock exchanges react to facts in only 10 percent of all cases – everything else is psychology”
Therefore, it is rather an interaction between money and psychology than just rational decision making.
The list of mental fallacies and theories of behavioral finance is long. With some understanding and willingness to own mistakes most fallacies are preventable from the outset since they have one fact in common: they are simply human. Most of these fallacies follow a typical pattern which all individuals (including experts) are subjected to, more or less. This article concentrates on the decision-making process of traders and examines which traps the mind is undertaking to influence an investors behavior.
Information Overload and Availability Bias
Imagine a trader twenty years ago. If he wanted to get information about a company’s performance, he was obligated to purchase a daily newspaper to look up the closing price of the previous day. Nowadays, the internet offers myriad sources with so called experts, who dabble at forecasting the next big trend.
This has both advantages and disadvantages for investors. Usually, more information is better than less. The problem is that information neither represent knowledge nor investment insights. Traders are encouraged to investment decisions without the ability to check their validity. In the daily flood of news, it is difficult to filter the relevant information. Many investors rely on any information that are easy to recall back into memory (also referred to as availability bias). Those are often the most-recent or emotionally charged information. It is often overlooked which messages are most important. Hence, it is advisable to keep a healthy distance from journalists who call themselves experts. Before following some dubious assumptions, it is always recommended to compare several perspectives to prevent availability biases. Additionally, it turned out that the exchange with colleagues and like-minded people becomes a far more reliable source because they already filter the relevant information for you.
Social Proof and Overconfidence
Social Proof refers to the phenomenon where people feel more comfortable when the majority of other traders also invest in the same stock; even if the mass chooses wrong. In other words, they are relying on the collective intelligence. Social proof is the evil conduct behind the dot-com and real estate bladder. As more and more investors jump onto an already moving train, price movements will amplify disproportionately. The euphoria of explosive price rises undermines the judgment of investors. Who blindly follows the crowd can thus get in serious troubles. The explanation for this behavior is evolutionarily related. Imagine hunting in the Stone Age. What would you do, if suddenly all of your companions run away? You would probably follow their action because the group is probably in danger. Conclusion: Be careful on following mass trends. If the mood is almost euphoric and the courses seem to only go in one direction, you may think twice before you become a victim of your own greed.
Just as the the instinct to blindly follow the group, an optimistic behavior is also deeply rooted in the human nature. This has the purpose to keep a positive self-image. Unfortunately, it is also natural to overestimate own knowledge and own abilities – a phenomenon that is called overconfidence. Further, as it is with many fallacies, no one is excluded. Keeping this in mind, it is always advisable to picture the worst case scenario in order to assess the situation realistically. Likewise, a certain level of skepticism towards promising trends is recommended.
Home Bias and Anchoring
Investors often rely on the known and spare the unknown. The tendency of investors to prioritize investments in the domestic market disproportionately is called home bias. An excessive focus on the home market could be quite risky, though. The same applies to pension reserves in the form of company shares. Many people (especially in the US) have invested their pension savings on so-called 401 (k) plans in the stock of their company. The problem is that with a bankruptcy of the company employees do not only lose their jobs but also their savings for retirement. Thus, from the viewpoints of risk diversification and asset allocation, investors should diversify their investments as widely as possible. That way, each investment will correlate with each other as little as possible.
Besides the home bias, there is an other fallacy that influences trader to rely on irrational information. The so-called anchoring describes the tendency to adhere on certain information rather than assessing the situation continuously and thoroughly evaluating it on the basis of all available, current information. Some investors, for instance, cling to a particular historical price level at which they have made a previous investment. Even professional analysts can fall into this trap. Prognoses of corporate profits are usually measured on last year’s results but may not take recent changes in the local environment into account. The negative impact of anchoring is exacerbated by other behaviors, such as information overload, social proof and overconfidence. Moreover, to avoid anchoring is extremely difficult. James Montier, one of the leading authors on the subject of Behavioral Finance, makes an interesting and practical proposal: investors are advised to accept the anchor effect willingly (as they are exposed to it anyway) but to hold on to something meaningful which is predictive of a forecast, e.g. dividends.
Whether private investor or institutional trader – the stock market is substantially led by emotions. Greed, euphoria, anxiety and panic are inevitable behavioral patterns that often can not be controlled. Investors often forget their own investment strategy and react any profit opportunities they see in the current market. Traders probably may not change the mindset of their brains. However, they can increase the awareness that they are prone to these mental fallacies. Once they are familiar with the potential pitfalls, they can avoid them in the future and train themselves to be more structured and less led by emotions actions.