Psychology and Investing: Part 1 - Behavioral Finance

An introduction to behavioral finance and why it matters to investors

Behavioral Finance

As investors, we believe successful investing only relies on gathering data, filtering information, and properly analyzing value.

The part glossed over is the fact that we're human beings, and emotion tends to play as big a role in success, or failure, as any other factor.


“Everyone has the brain power to make money in stocks. Not everyone has the stomach.” — Peter Lynch




Summary

  • Successful investing is dependent on analysis, valuation, AND psychology.
  • While conventional wisdom states that markets are efficient and investors behave rationally, the real-world has shown time and time again markets and people often act irrational and unpredictable.
  • Behavioral finance is a developing field that combines behavioral and cognitive psychology with conventional theory in order to explain how emotion can interfere with financial decisions.
  • Analyzing these traps and biases is critical to investing success.



Psychology and Investing

Investing is easy, successful investing is a little more difficult, but still doesn't require a genius IQ like some would have you believe. While you must take the time to do your homework, perform proper fundamental analysis, and determine intrinsic value with relative accuracy, the true test of investing success is often found within ourselves, mainly our emotions. As Peter Lynch stated, brainpower is typically not the problem, overcoming inherent psychological weaknesses is where investors trip up. Warren Buffett seems to agree. Nevertheless, emotion and psychology is too often overlooked as people focus on where their analysis went wrong or why they cannot pick better stocks. But behavior finance is trying to change all of that.



“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.” — Warren Buffett

Modern Portfolio Theory (MPT), Capital Asset Pricing Model (CAPM), and conventional academic assumptions are all based on the hypothetical notion that markets are efficient and people act rationally. If this is true, then I ask you:

  • Why do stock market bubbles occur?
  • How do automated investing strategies fail?
  • Why does value investing have a great track record?

Answering these questions will undoubtedly be tough if you believe in the aforementioned theories. Especially given how real world data, and now behavioral finance, are proving that these obsolete convictions just that, obsolete. If the best you can do is average the market someone should inform Warren Buffett, Peter Lynch, Seth Klarman, and, well you get the point.




Introduction to Behavioral Finance

But why isn't the market efficient? Why don't people act rationally? Enter behavioral finance. While conventional theory excludes emotion and states that markets are efficient because people, for the most part, make "rational" decisions to increase wealth and well-being, the real world has proven to be quite an irrational place where emotions run wild, causing people and markets to rarely behave predictable.

“Market prices are set by herds of emotional, greedy, or depressed persons who do not always act rationally.” — Warren Buffett

Behavioral finance is a relatively new field that attempts to explain why in the world people would make investing decisions conflicting with their own interests. It combines behavioral and cognitive psychological theory with conventional wisdom in order to do this.




Why it Matters

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” — Benjamin Graham

The above quote states why behavioral finance matters, especially to individual investors. Analyzing and identifying various types of psychological traps, biases, and other negative emotions that can affect your investing decisions is critical to success. But while behavioral finance focuses on larger trends, such as market movement, I want to concentrate on the benefits the field can provide for the individual investor. So stay tuned and check out part 2 and 3 where we'll go over prospect theory and several traps and biases you should be aware of.