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The Importance of Behavorial Finance Studies

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Behavioral finance is a fascinating branch of financial theory, combining the rigor of statistical analysis with the psychological nuances of financial participants. Many of our most common pearls of market wisdom, such as "sell your losers and let your winners run," are useful shorthand for avoiding biases that can lead to poor investment decisions.

Perhaps the most important finding of behavioral finance is that people hate to lose.

Warren Buffett

once commented that "there are two rules in the stock market. Rule Number One: Don't lose money. Rule Number Two: Don't forget rule number one." Although not liking to lose is understandable, behavioral finance shows that it's easy to let loss aversion result in irrational decision making.

Framing a decision as either a loss or a gain can have a very powerful impact on the majority response.

Amos Tversky

and

Daniel Kahneman

wrote a series of influential articles in the late 1980s, several of which included the following example illustrating the power of decision framing.

Problem asked of 150 people.

Imagine that you face the following pair of concurrent decisions. First examine both decisions, then indicate the options you prefer.

Responses are in brackets after the question.

Decision 1 - Choose between:

A. a sure gain of $240

84%

B. 25% chance to gain $1,000

16%

Decision 2 - Choose between:

C. a sure loss of $750

13%

D. 75% chance to lose $1,000

87%

The majority of respondents chose A and D, a combination of choices that resulted in their having a 25% chance of winning $240 and a 75% chance of losing $760. The rational economic choices would have been B and C, resulting in a 25% chance of winning $250 and a 75% chance of losing $750.

The frame within which the decisions were couched -- gain versus loss -- dramatically affected the responses. People as a whole tend to be risk-averse on the upside and risk-seeking on the downside, and these tendencies can lead to irrational decisions. Guarding against such irrational tendencies lend legitimacy to market maxims such as "hold your winners and sell your losers."

Within the Investment Process -- the Selling Analyst

Framing of decisions is clearly a source of potential bias, but a simple awareness of the bias is probably all that is necessary for improving the investment process. As an example of going too far, one of my old firms developed the concept of a "selling analyst" who would always bring the negative story to our investment council.

Consultants loved the concept, and our selling analyst became a valuable part of the marketing pitch to some sophisticated clients. In reality, however, the selling analyst caused a lot more harm than good, and he was eventually ignored. The analyst, although extremely competent, was unable to develop meaningful input for the broad array of positions held by our money management firm. In the end, a good analyst must be his own selling analyst, constantly shifting perspective from positive to negative in an attempt to reach a rational position on the stock.

Similarly, many of the findings of behavioral finance, although interesting, can be blown out of proportion. It is particularly dangerous to take an observed inconsistency from psychological testing and assume that the stock market is mispriced due to this bias. Effectively, behavioral finance tempts the investor into assuming that the market is stupid, and in my experience that is very dangerous. My personal maxim is that there are no stupid markets, only stupid investors.

Summary of Behavioral Idiosyncracies

Rather than offering prescriptions for successful investing, behavioral finance is most useful in helping investors identify idiosyncracies to guard against in their own investment process. Listed below are several instances wherein behavioral finance has found people on average to make systematic, noneconomic decisions, along with my translation of those biases into useful investing maxims.

Behavior:

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People tend to find losses proportionately more painful than gains.

Translation:

Don't allow a current gain or loss in a stock to affect your investment decision.

Behavior:

People perceive patterns more easily than details.

Translation:

Thematic investing should be supported by specific company analysis.

Behavior:

There is a higher perceived value placed on assets that people own than on assets not owned.

Translation:

Don't fall in love with a stock.

Behavior:

Individuals tend to make decisions that are backed by the majority.

Translation:

Be wary of a herd mentality.

Behavior:

People show an orientation towards inaction, linked to an aversion to incurring regret.

Translation:

Investment positions should be systematically reassessed.

Behavior:

People tend to assign disproportionately high weights to small probabilities.

Translation:

Be wary of longshots.

Behavior:

People are usually overconfident in their judgment of the probablility of an event.

Translation:

Earnings surprises will remain an inevitable part of the investment landscape. A rational response to unexpected news should be part of the investment process.

Ted Murphy ( ted@pdgm.com) operates the MarketPlayer Web site. Prior to MarketPlayer, he was a partner at

Equinox Capital Management.