Let’s continue where we left off – the key concepts of behavioral finance. For the Part 1 of this article, please click here.
Fight or Flight Instinct: When captain caveman was walking in the tundra and suddenly ran into a lion, he had 2 options: fight or flight. If the lion was old and sick and if the caveman was a gifted spearman, maybe he had chance of killing the lion to live another day. This is the fight option. His other option is flight – which is to run while saying a few prayers before becoming cat food. Today, when markets show teeth by plummeting, most investors choose the flight option and sell their assets while some brave choose to fight by staying in the game or – better yet – by purchasing securities at discount prices.
Herd Mentality: “They can’t all be wrong, but if the signs of a draught are real, we must all leave these lands. If I stay here with my family, we may not survive.” Sometimes, we are all wrong and there is comfort in that. However, if you are the only one who is wrong, that can hurt. History shows that investors usually act like a herd of hungry predators and buy assets regardless of their prices. This behavior leads to bubbles and bubbles occur on a regular basis. For example: Dutch Tulip mania (17th century), British South Sea Bubble (18th century), Great Depression (1920s), tronics boom (1960s), The Nifty Fifty (1970s), biotech frenzy (1980s), Japanese stock and real estate market crash (1990s), dotcom crash (2000s), real estate market crash (2008).
Hindsight Bias: After heavy rains caused by the storm washed away the tribe’s camp site, the elder leader claims that he knew the storm was coming all along because the clouds had a distinct gray color. Or, when the tribe’s hunters come back empty handed after a long hunting trip, some of them claim they knew they wouldn’t catch anything because they haven’t seen any meaningful animal tracks. The truth is, sometimes past events seem that they were predictable and obvious only after they come to pass. This fallacy gave our ancestors a false sense of security and confidence. It also gave them more morale and motivation to go out and try to make a living. As of today, don’t we all have that friend who claims he knew the last market crash was coming all along but never mentioned it before the crash?
How to avoid these behaviors?
Loss Aversion: Understand the risk you are taking and make sure you are comfortable with it (i.e. percentage of your portfolio in stocks, weight of a given stock in your portfolio or amount of cash you have). Do not overreact to news or short-term market volatility (up or down movements). Stick to your financial plan.
Overconfidence: Be humble and remember that information you have available to make your investing decisions is also available to professional fund managers. Ask yourself this question: “What do I know that Wall Street doesn’t know?”
Confirmation and Hindsight Bias: Seek opinions contrary to yours. You don’t have to agree with them but at least try to understand the reasoning.
Fight or Flight Instinct: When market volatility increases, keep the long-term perspective in mind and stick to your financial plan.
Herd Mentality: Warren Buffet said: “Be fearful when others are greedy and greedy when others are fearful.”. I don’t think we should say any further…
We all have been a victim of one of these behaviors. Hopefully this information – combined with a solid long-term financial plan – will make you a better investor. Below are a few books on behavioral finance that I would recommend. Enjoy!