Lessons from Behavioral Finance

In an article entitled “How to ignore the yes man in your head” Jason Zweig describes a method suggested by noted psychologist Gary Klein.  Imagine that all of your positions have imploded.  This exercise can inject some balance into your thought process.

Another simple approach is to have a trading colleague review your holdings and play devil’s advocate by pointing out potential negatives for each position.

Anchoring

Humans often use mental shortcuts to help them evaluate the unknown. Given a new problem, people often make an initial “guesstimate” of what the solution could be, and then start adjusting that estimate as they uncover more information.  The initial estimate is called the anchor. 

Examples of anchoring abound in everyday life.  The seller of real estate lists a property at a very high price (the anchor) so that any subsequent reductions will be seen as offering a good value.  Or we estimate the population of a new city we visit by comparing it to a city with which we are familiar.

A potential problem with anchors, though, is that these initial values are not always set rationally.  For example, in one study, Tversky and Kahneman asked groups of people to guess what percentage of African nations were members of the United Nations.  When the question was phrased “Was it more or less than 10%?” the average estimate was 25%.  But when the question was phrased “Was it more or less that 65%?” the average estimate jumped to 45%.

Anchoring can cause traders difficulties.  For example, suppose three months ago a stock was trading at $100, and now is trading at $60.  Traders often anchor to the previous high and therefore see the current price as an attractive value.  The thought of buying at a “discount” or “bargain price” can be alluring.  Sometimes a sharp price decline can indeed offer an opportunity.  But what if three months ago the stock was trading at $100 because of a product launch that was expected to increase earnings, but now because of weak sales, the revenue gain hasn’t materialized.  Even at $60 the stock might not be undervalued. 

Traders can combat irrational anchoring by using multiple criteria to evaluate ideas.  Relying too heavily on just one discipline, such as fundamental or technical analysis, can lead to erroneous decision making.

Understanding the key concepts of behavioral finance can keep traders from making avoidable mistakes.  As Shakespeare wrote centuries ago, “the fault, dear Brutus, lies not in the stars but in ourselves.”

Lee Bohl can be contacted at Charles Schwab