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Lessons from Behavioral Finance

Lee Bohl

According to traditional financial and economic theories investors are assumed to be rationalactors, seeking to maximize their wealth in logical ways. But in the real world investors andtraders often act irrationally and unpredictably, often to their financial detriment. Behavioralfinance 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 cognitiveerrors repeatedly committed by financial market participants. By understanding some of behavioral finances key concepts, traders can avoid some of the common pitfalls that can wreakhavoc 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 losebut what might surprise you is that the psychological impact of wins and losses of the samemagnitude is not the same. According to research conducted by nobel laureate DanielKahneman 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, isat 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 andhoping that they can make back the loss. Hersh Shefrin, one of the leading authorities onbehavioral finance, went so far as to say the two main emotions that drive investors actions arenot fear and greed, but rather, fear and hope. He coined the term disposition effect todescribe 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 doesnt 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 BrianHunter whose 6 billion dollar loss on natural gas futures led to the dissolution of the Amaranthhedge fund?

So how can traders fight against this tendency to hang on to losing positions for too long? Bysimply setting a predetermined exit price prior to entering the trade and sticking to it with noexceptions, ever. And also by remembering the oft quoted aphorism that hope is not a validtrading strategy.

Confirmation bias

Confirmation bias refers to the strong tendency people have to seek out and give moreattention 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 isapproaching political and financial Armageddon and then starts constantly scanning news sitesfor calamitous stories to validate that view while ignoring clear signs of improving economicconditions. Or a trader buys a stock, sees it drop through a clear support level and then, insteadof selling, starts searching news feeds and websites for reasons to continue holding, or evenworse, to buy more.

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There are ways, however, that traders can fight against confirmation bias. Legendarycommodities 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 methodsuggested 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 devilsadvocate 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 startadjusting that estimate as they uncover more information. The initial estimate is called theanchor.

Examples of anchoring abound in everyday life. The seller of real estate lists a property at a veryhigh 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 arefamiliar.

A potential problem with anchors, though, is that these initial values are not always setrationally. For example, in one study, Tversky and Kahneman asked groups of people to guesswhat percentage of African nations were members of the United Nations. When the questionwas phrased Was it more or less than 10%? the average estimate was 25%. But when thequestion 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 wastrading at $100, and now is trading at $60. Traders often anchor to the previous high andtherefore see the current price as an attractive value. The thought of buying at a discount orbargain price can be alluring. Sometimes a sharp price decline can indeed offer anopportunity. But what if three months ago the stock was trading at $100 because of a productlaunch that was expected to increase earnings, but now because of weak sales, the revenue gainhasnt materialized. Even at $60 the stock might not be undervalued.

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

Understanding the key concepts of behavioral finance can keep traders from making avoidablemistakes. As Shakespeare wrote centuries ago, the fault, dear Brutus, lies not in the stars butin ourselves.