Using Behavioral Finance to Impact Your Earning Power

Using Behavioral Finance to Impact Your Earning Power

The strategy game Othello is famous for carrying the tagline, “A minute to learn, a lifetime to master.” Investors today should commit this phrase to mind, it’s a reminder of the limitless challenges inherent to the simple act of buying and selling.

For many, these impediments to wealth are elements like volatility, disruptive geopolitical news, and competitive market forces. The most basic tenants of wise investing require minutes to learn. However, the skills necessary to master the pursuit are endless and as some researchers have postulated, unseen. That is, the most counterproductive aspect of irrationality in the market is also the most counterintuitive; the enemy of your wealth is you.

The field of behavioral finance endeavors to understand how our biases and flawed thinking drive irrationality in the financial world. In this article, we’ll look at the discoveries of behavioral finance experts and see how to apply them to our financial goals.

The Origins of Behavioral Finance

Traditionally, formulas, equations, and models formed the underlying latticework of the markets. However, researchers have witnessed irrationality in finance emanating not from these mathematical factors but rather cognitive bias rooted in emotion. Founders of the field set out to introduce psychological theory into the discussion of understanding the market. Behavioral finance researchers have applied the results of psychological studies to fill the gaps in our understanding of why the market ventures outside rationality.

This field is relatively new. Some of the earliest published articles date back only as far as the 1960s. Scientists examined how uncertainty and risk influence decision-making. When the complexity of the situation is too taxing for a conventional, analytic approach, we resort to heuristics or shortcuts to thinking. These heuristics ignore the required rigor for challenging problems. Instead, they seek to reach a quick decision to satisfy an issue immediately. Let’s take a closer look at some of these specific flaws and how we can circumvent their influence.

Pitfall 1: Herd Behavior

The most elusive lessons are the ones we learn repeatedly. Herd behavior is a cognitive bias seen with nearly every market crises. This bias leads us to believe that the popular decision is appropriate. When we see a crowd run in one direction, we tend to follow. The problem is that the general populous is often wrong. On an institutional level, this was the case with the housing crises. Banks began to embrace collateralized debt obligations as more institutions engaged in these risky transactions. In the early years of the 21st-century, investors dumped billions into emerging dot-com businesses in the hopes of quick wealth. Herd behavior accelerated all of these activities. An investor can do well if they avoid the ingrained impulse to follow crowds.

The temptation to engage in this behavior is not surprising; critical thought is taxing, and the herd mentality is a shortcut. Simply being cognizant that this bias is at work can serve an investor over the long term. The valuable trades are rarely the ones every investor is discussing. As Warren Buffet once remarked, “Be fearful when others are greedy and greedy when others are fearful.” The active trading that results from this bias generates added transactional costs. Equally problematic are the baseless valuations escalated by “irrational exuberance” that often plague the market.

Avoid herd behavior by basing investment decisions on the fundamentals of the market. Remain vigilant of the flaws inherent in the masses clamoring for quick riches. Be proactive and put your long-term strategy on paper. When you feel drawn to the cacophony of the market, return to the plan you’ve written for yourself.

Pitfall 2: Gambler’s Fallacy

Imagine someone rolls a die ten times. Every roll lands on the number four. On the next roll nearly anyone would bet that it wouldn’t land on four. After all, how many times can the same value come up? This scenario illustrates the gambler’s fallacy at work. We often fail to acknowledge that each event is independent. The outcome of the ninth roll is in no way influenced by the roll that came before.

Investing creates the perfect atmosphere for this kind of bias to take hold. We see a security rise in value day after day. Before long we believe this growth will become unsustainable. The result: we sell the security too soon. Compounding this effect is the simultaneous belief that another holding experiencing daily drops will eventually bottom out. In truth, the security is unaware of the previous day’s activity and these movements alone don’t influence the future.

Don’t use the trading history of the asset to drive your decision to buy or sell. Instead, form a long-term strategy based on the fundamentals of the assets. Fluctuations are part of the market cycle and unavoidable to any investor.

Pitfall 3: Information Bias

When we seek out volumes of information that have little or no impact on the outcome of a decision, we are engaging in information bias. In our era of digitized and easily accessible information, this bias is ever-present. The simple task of gathering data is too often confused with analysis. By collecting figures and measurements, we believe we are “doing our homework” when in fact we haven’t taken the time to understand and synthesize the information. More information doesn’t increase the probability of a sound decision.

Consider this fallacy when investing. There is no need to embrace a sea of data when in fact the critical data points can be summarized in a short list. Many online trading platforms offer deep analytics at high monthly subscription fees presenting a two-fold problem for investors. First, the added cost defrays any gains from investments. Second, the complexity and breadth of the information are a distraction from the more meaningful core fundamentals. These fundamentals are all that’s needed to make a smart decision.

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Ben Taylor, MBA has written for Business Insider, Seeking Alpha, Nasdaq, and many others. His writing offers simple insight from otherwise complex financial concepts.

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