How Behavioral Investing Can Help You Outsmart The Markets

10 mins

How Behavioral Investing Can Help You Outsmart The Markets

When you’re making an investment decision (or just thinking about money) do you suffer from any of the following symptoms: increased heart rate? A feeling of choice paralysis? Constantly second-guessing yourself?

These are all signs that you’re not a cold-blooded and completely rational machine when investing. But that’s okay – you’re human. No one is always 100% unemotional – even if for years economists assumed people acted that way.

For most of the 20th century, mainstream economists taught that markets are what they called “efficient” – that prices of stocks and bonds reflect all the information that’s available. And that market movements were down to human beings processing all this information rationally and therefore making rational decisions.

In this perfect model, it’s theoretically impossible for an investor to beat the market consistently – any gains over and above the wider climb in prices of stocks or bonds would be purely luck.

More recently, which in research terms means over the last few decades, a whole new scientific area looking at irrationality has emerged. A field known as behavioral finance has grown up at the intersection of economics and psychology – and has become an increasingly popular way to demonstrate humans’ irrational actions and how they can feed through to markets.

It’s still a controversial field, with plenty of investors and economists clinging to the idea of markets being efficient and rational in the long term and writing off all the observed experimental findings as little more than short-term ripples.

If you understand how and why you act irrationally, you can take steps to counter it and hopefully make better decisions. You can also take it one step further and look at ways to profit from the irrationalities of others.

The founding fathers of behavioral finance – Daniel Kahneman and Amos Tversky – discovered that there are certain ways that people consistently behave irrationally. The Tversky and Kahneman dream team found a host of heuristics – a fancy word for mental shortcuts – to which we all resort.

For example, human brains can be quick to draw cause-and-effect conclusions from very limited data. And we can be easily primed to under- or overestimate the likelihood of an event happening. For example, experiments show that we massively increase our estimate of the chances of a train crashing if we’ve just seen footage of a crash on the news. These totally understandable but not very rational mental tropes can hinder our investing decisions.

Believe it or not, these intuitive thought patterns are there for a good reason. They help us all quickly assess situations in dangerous or fast-paced environments. If you see a shadow in the woods that looks like a bear, it’s ultimately safer to assume it is a bear and be prepared to run away. Now bear attacks are less common, however, these heuristics can sometimes lead to some questionable decision-making.

These mental shortcuts which help you stay alive in this big bad world can make you biased. Biases can make you jump to incorrect conclusions, which are especially relevant in the world of investment.

Kahneman’s 2011 book Thinking, Fast and Slow is a wide-ranging discussion of the glorious frailties of the supposedly rational human mind. Examples he gives of our feeble minds include a bet where participants are given the chance to toss a coin. If they flip heads they win $200; if it’s tails they lose $100. A rational person would take this bet every time. But a surprising number of real people turn it down, because the pain of a loss so outweighs the joy of a gain.

Now imagine two investors: Sarah and Kai.

  • Kai owns shares in Company A. He recently considered switching to stock in Company B, but didn’t. He now learns he would have been better off by $1,500 if he’d switched.
  • Sarah used to own shares in Company B, but she recently switched to stock in Company A. She now learns she would have been better off by $1,500 if she hadn’t switched.

When asked who feels greater regret, a whopping 92% of people say Sarah, according to Kahneman. While the two situations are objectively the same in terms of financial outcomes, it seems that people experience greater regret from performing an action than from remaining inactive.

Perhaps this finding is at the heart of why some people struggle to take the plunge and invest at all!

Let’s look at some of the other ways you probably act irrationally. We all have certain mental biases it can be hard to overcome – especially when thinking about money.

First off, let’s hit the sales. If you find yourself making an impulse purchase because something is discounted, you’re probably experiencing an effect known as anchoring. Your mind fixates on the original price and adjusts from there. That’s why discounts can be so effective at driving sales. Your brain is valuing the item at the initial price, and you automatically see everything else as a bargain. It’s particularly important to think about anchoring when negotiating. If you enter negotiations at a high starting price, any discount by the seller is going to look like more of a bargain – even when it’s not.

Another common mental flaw is known as confirmation bias. When you hold a certain viewpoint or have an idea, you are more likely to notice evidence that supports it – and discount that which contradicts the premise. This confirmation bias can be particularly tricky to avoid when it comes to investing. When coming up with an investment thesis, don’t forget to take time looking for evidence that might disprove your grand theory.

The pull of the crowd can also be very powerful. Herd mentality or bandwagon bias, which is the desire to follow popular opinion, is difficult to escape – it’s what most of us end up doing. It’s one of the main reasons why markets go through boom and bust cycles. Cryptocurrencies in 2017 were a perfect example: masses of people kept buying until some were eventually snapping up digital cats for $150,000! When everyone is zigging, sometimes you need to consider zagging.

Of all the biases related to investment, one trumps them all. We all, obviously, dislike losing and enjoy winning. But did you know that we hate to lose much, much more than we like to win? (Think back to the coin-toss experiment.)

This is called loss aversion bias and can run so deep that it may affect every single investment decision you make. One common way that loss aversion manifests itself is a reluctance to let go of bad decisions. For instance, you might have sunk cash into a dodgy stock that keeps dropping, but you’re refusing to cut your losses. Instead, you might be harboring unrealistic hopes of a miraculous recovery; or perhaps you’re just unwilling to face the loss. Either way, it spells trouble for your investments.

Are you spotting some of the above biases in your own investment decisions? Next we’ll talk about strategies that can be put in place to counter them.

It turns out your surroundings massively influence your actions. For example, you’re more likely to go for a run if you leave your running shoes by the door than if they’re stashed away in your smelly sports bag. This is known as nudging and involves making small changes to your environment. It can have a significant impact on your overall behavior, and better aligning what you do with what you want.

There are many nudges you can put in place to help improve your investment decisions and decrease the likelihood of making rash and poor choices. A trading journal is one of the most simple yet effective practices you can implement. Moving ideas from your brilliant mind to good old-fashioned paper (or a Google doc if you want to be all modern) can help you avoid a lot of irrationalities.

For example, if you note down the maximum amount you’re willing to lose on any investment, it’s easier to hold yourself to account if it goes sour. And if you record your reasons for buying into an investment before you hit the button, it will help you decide whether you’ve thoroughly thought it through or if you’re merely taking a punt based on impulse.

Confirmation bias can easily sneak in and influence your investment decisions. Even when all the evidence points to an investment being a good idea, never lose your skepticism. One thing you can do is actively search out the best argument against your investment before making your final decision.

Daniel Kahneman also recommends checking on your investments infrequently – say once a quarter instead of every few days. He argues that every peek at the performance of your portfolio is just an opportunity for distress, because you’re likely to be more upset by any losses than pleased by your gains. More frequent checking-in might also cause you to fruitlessly “churn” your investments – potentially selling those that are doing well prematurely or racking up trading fees with your broker.

It’s worth bearing in mind that the worst biases occur when you’re forced to rush a decision, because this is when your mind will jump to mental shortcuts. Always take a breath and find more time to ponder before making an investment.

So now we arrive at the million-dollar question… can you, as an investor, capitalize on the irrationalities of others?

Professional investors have been pondering this question for years and have identified certain recurring patterns in market movements that might reflect our irrational nature. This is known as factor investing: and it’s a whole field dedicated to capitalizing on our human shortcomings.

Factors are essentially market behaviors that repeat themselves, presenting an opportunity for investors to profit from the patterns – given enough time.

The trend factor, for example, suggests that top-performing stocks are likely to continue to perform well. A related factor known as momentum suggests that stocks which have recently been rising relatively more than their peers will continue to do so. And value identifies stocks that are cheaper than the wider market, in the hope they’ll outperform over time.

Seasonality, meanwhile, looks at price patterns related to the time of year. The stock market seems to have historically performed better in certain months, for example, leading to traders talking about “sell in May and go away” and the market being due for a “Santa rally”.

The idea that following these sort of blanket rules might be a good trading strategy probably sounds a bit nuts at first. But researchers have mined available datasets going back more than 200 years and found that they’ve so far stood the test of time – though nobody can be 100% sure that these factors will continue in future. It may be that 200 years isn’t a long enough time period to iron-out the wrinkles of randomness.

Nowadays there are plenty of exchange-traded funds (ETFs) that will mimic these factors for you – known as smart beta ETFs. For example, the iShares Edge MSCI USA Momentum Factor ETF aims to implement a momentum strategy (with the funky ticker MTUM). There are also ETFs for volatility (e.g. SPLV), for stocks that pay dividends (e.g. VIG)... Whatever floats your boat.

We’ve got a whole other pack on ETFs & Smart Beta if you want to go deeper into this topic. You can also try your own hand at factor investing, but it’s best to keep your journal close! If you want to make momentum and trend trades it’s a good idea to jot down what’s working, and what would have been better off left well alone.

That’s it for our bittersweet behavioral investing pack! Now you know that you’re probably not as rational as you’d like, but you’ve also learned some ways to tackle this – it and potentially profit from it.

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