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Lessons from Behavioral Finance
28 Sep, 2012
by Lee Bohl

According to traditional financial and economic theories investors are assumed to be rational actors, seeking to maximize their wealth in logical ways.  But in the real world investors and traders often act irrationally and unpredictably, often to their financial detriment. Behavioral finance is a discipline that blends psychology and finance to help explain why investors act the way they do. Over the last few decades behavioral theorists have identified a set of cognitive errors repeatedly committed by financial market participants.  By understanding some of behavioral finance’s key concepts, traders can avoid some of the common pitfalls that can wreak havoc on their account balances.

Loss aversion and the disposition effect

It should come as no surprise that people feel pleasure when they win and pain when they lose but what might surprise you is that the psychological impact of wins and losses of the same magnitude is not the same.  According to research conducted by nobel laureate Daniel Kahneman and Amos Tversky people feel the sting of a loss two and a half times more strongly than the pleasure of a gain of the same size.  This phenomenon, often called “loss aversion,” is at the root of one of the most common of all trading mistakes- holding on to losers for too long.

Traders faced with a losing position seek to avoid the pain of exiting at a loss by holding on and hoping that they can make back the loss.  Hersh Shefrin, one of the leading authorities on behavioral finance, went so far as to say the two main emotions that drive  investors actions are not fear and greed, but rather, fear and hope.  He coined the term “disposition effect” to describe the predisposition traders have to hold on trying to break even.”  

This mistake is made over and over by not only retail investors but by institutional ones as well.  Who doesn’t remember Nicholas Leeson, trader who caused the collapse of his centuries old employer Barings PLC by holding on to positions that eventually lost 1.4 billion dollars?  Or Brian Hunter whose 6 billion dollar loss on natural gas futures led to the dissolution of the Amaranth hedge fund?

So how can traders fight against this tendency to hang on to losing positions for too long?  By simply setting a predetermined exit price prior to entering the trade and sticking to it with no exceptions, ever.  And also by remembering the oft quoted aphorism that hope is not a valid trading strategy.

Confirmation bias

“Confirmation bias” refers to the strong tendency people have to seek out and give more attention and weight to new evidence that supports their beliefs than that which refutes them.  This bias can lead to trouble.  For example, a trader buys gold after deciding that the world is approaching political and financial Armageddon and then starts constantly scanning news sites for calamitous stories to validate that view while ignoring clear signs of improving economic conditions. Or a trader buys a stock, sees it drop through a clear support level and then, instead of selling, starts searching news feeds and websites for reasons to continue holding, or even worse, to buy more.

There are ways, however, that traders can fight against confirmation bias. Legendary commodities trader Paul Tudor simply put a sign over his desk that read “losers average losers.” to help him combat the temptation to average down into a losing position.

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

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