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An Introduction To Behavioral
Finance
By Ben McClure

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It's hard not to think of the stock market as a person: it has moods that can turn
from irritable to euphoric; it can also react hastily one day and make amends the
next. But can psychology really help us understand financial markets? Does it
provide us with hands-on stock picking strategies? Behavioral finance theorists
suggest that it can.

Tutorial: Behavioral Finance

Tenets and Findings of Behavioral Finance

This field of study argues that people are not nearly as rational as traditional
finance theory makes out. For investors who are curious about how emotions
and biases drive share prices, behavioral finance offers some interesting
descriptions and explanations.

The idea that psychology drives stock market movements flies in the face of
established theories that advocate the notion that markets are efficient.
Proponents of efficient market hypothesis say that any new information relevant
to a company's value is quickly priced by the market through the process
of arbitrage. (For further reading on market efficiency, see Mad Money ... Mad
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Market?, Working Through The Efficient Market Hypothesis and What Is Market
Efficiency?)

For anyone who has been through the Internet bubble and the subsequent crash,
the efficient market theory is pretty hard to swallow. Behaviorists explain that,
rather than being anomalies, irrational behavior is commonplace. In fact,
researchers have regularly reproduced market behavior using very simple
experiments.

Importance of Losses Versus Significance of Gains

Here is one experiment: offer someone a choice of a sure $50 or, on the flip of a
coin, the possibility of winning $100 or winning nothing. Chances are the person
will pocket the sure thing. Conversely, offer a choice of a sure loss of $50 or, on
a flip of a coin, a loss of $100 or nothing. The person will probably take the coin
toss. The chance of the coin flipping either way is equivalent for both scenarios,
yet people will go for the coin toss to save themselves from loss even though the
coin flip could mean an even greater loss. People tend to view the possibility of
recouping a loss as more important than the possibility of greater gain.

The priority of avoiding losses holds true also for investors. Just think of Nortel
Networks shareholders who watched their stock's value plummet from over $100
a share in early 2000 to less than $2. No matter how low the price drops,
investors, believing that the price will eventually come back, often hold onto
stocks..

The Herd Versus the Self

Herd instinct explains why people tend to imitate others. When a market is
moving up or down, investors are subject to a fear that others know more or have
more information. As a consequence, investors feel a strong impulse to do what
others are doing.

Behavior finance has also found that investors tend to place too much worth on
judgments derived from small samples of data or from single sources. For
instance, investors are known to attribute skill rather than luck to an analyst that
picks a winning stock.
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On the other hand, investors' beliefs are not easily shaken. One belief that
gripped investors through the late 1990s was that any sudden drop in the market
is a good time to buy. Indeed, this view still pervades. Investors are often
overconfident in their judgments and tend to pounce on a single "telling" detail
rather than the more obvious average.

How Practical Is Behavioral Finance?

We can ask ourselves if these studies will help investors beat the market. After
all, rational shortcomings ought to provide plenty of profitable opportunities for
wise investors. In practice, however, few if any value investors are deploying
behavioral principles to sort out which cheap stocks actually offer returns that can
be taken to the bank. The impact of behavioral finance research still remains
greater in academia than in practical money management.

While it points to numerous rational shortcomings, the field offers little in the way
of solutions that make money from market manias. Robert Shiller, author of
"Irrational Exuberance" (2000), showed that in the late 1990s, the market was in
the thick of a bubble. But he couldn't say when it would pop. Similarly, today's
behaviorists can't tell us when the market has hit bottom. They can, however,
describe what it might look like.

Conclusion
The behavioralists have yet to come up with a coherent model that actually
predicts the future rather than merely explains, with the benefit of hindsight, what
the market did in the past. The big lesson is that theory doesn't tell people how to
beat the market. Instead, it tells us that psychology causes market prices and
fundamental values to diverge for a long time.

Behavioral finance offers no investment miracles, but perhaps it can help

investors train themselves how to be watchful of their behavior and, in turn, avoid
mistakes that will decrease their personal wealth.
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An Introduction to Consensus
Indicators
Psychology is the often overlooked intangible aspect of trading, because it is
unquantifiable and generally misunderstood by most traders and investors. (See
also: How To Read The Market's Psychological State.)

Unlike the precise mathematical formulas used in technical analysis, we cannot

easily reduce human behavior to a mathematical equation that can be plotted on
a graph as a trendline or as a series of variables that we can examine in detail,
throughout history. (See also: Technical Analysis.)

That said, much of the current research in social sciences is attempting to bring
psychology more in line with mathematics for the precision that it gives to
experimental methods. Mathematical methods are applied to behavioral science
for the purpose of observing and comparing human behavior, according to a set
of strict numerical criteria, the only stable benchmarks that allow comparison of
behavior from person to person and from time to time. (See also: An Introduction
to Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad
Market?)

In relation to trading and investing, we can consider two very different

approaches to psychology in the markets: individual psychology and group
psychology. Individual psychology obviously only looks at the behaviors of the
single individual trader. Attempting to draw conclusions based on the actions of
the herd, mass psychology (or group psychology or crowd behavior) examines
how behavior of all investors exerts an effect on a stock price (or option price or
currency value). (See also: The Importance of Trading Psychology and
Discipline.)

Go Against the Grain

The foundations of how crowd behavior relates to investing are rooted in distant
history, all the way back to the famous early 17th-century Dutch tulipmania of
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investing folklore. Interestingly, the behavior of crowds is a paradoxical indicator

when applied to stock markets. When most investors are in consensus and are
driving the market in a particular direction, one naturally thinks that the
consensus will continue ad infinitum and that the best trading decision is to follow
the crowd. (See also: How the Power of the Masses Drives the Market.)

However, history has proven exactly the opposite. When driven strongly by
consensus, crowd behavior is actually a contrary indicator. When the consensus
of the majority of investors or traders is strongest, the individual trader should do
exactly the opposite of what the crowd is doing. The astute trader can profit by
doing quite the opposite of what, at first glance, seems logical. When the market
is strongly bullish, the astute trader is ready to short the market. When the
market is bearish, he or she gets ready to buy.

When and How?

You would not be faulted if you were to question this strategy of trading. How do
you know that the contrary trade is not going to be exactly the wrong action?
Mass psychology may continue to drive the trend for a longer period of time. How
can you expect to identify that exact magic moment, the single day or week,
when the consensus indicator is strongest, the absolute best time that you should
make your contrary move?

To answer these questions, traders must realize that a consensus indicator is not
meant to be an absolutely precise indicator. Market consensus should be used
as a clue that a trading opportunity is afoot. It indicates that it is a good time to
apply more detailed analysis into particular stocks or currencies. It is important to
find out if the trading opportunity is supported by technical analysis or momentum
indicators.

The second question I raised is the more interesting one. How do you identify
when the consensus is strongest? Several tools are used to help investors
roughly identify the consensus of the market. Most of these tools tabulate a
numerical consensus indicator on the basis of advisory opinions, including
signals from the press or advertisers.
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Advisory Opinion
The advisors of which I speak are ubiquitous newsletter writers who service their
subscribers week-by-week or month-by-month by giving opinions on the future
direction of markets or individual stocks. Sources such as Consensus and Market
Vane poll these newsletters to track the bullishness or bearishness of the market.
Even if the individual letter writers are blindly regurgitating whatever they hear in
the media, these polling services, because they have developed special methods
to analyze these newsletters, can assign either a bullish or bearish value to each
of the opinion letters. These services then tabulate the overall bullishness or
bearishness of their entire universe of advisors. When this numerical value
crosses a certain threshold, either a buy or a sell signal is issued. The signal is
issued contrary to the balance of advisory opinion.

The Press
By their very nature, financial journalists are fence sitters. Financial newspapers
and magazines do not ever want to be wrong in their opinions, so they present
reportage within their pages that is as innocuous and non-committal as is
humanly possible. Journalists' fence sitting only disappears at the end of a long
trend, when the balance of opinion among analysts, investors and the press has
reached a strong consensus.

At this time, the press will jump firmly onto one side of the fence or the other,
presenting strong opinions concerning the state of the market and its likely short-
term direction. When journalists have jumped to one particular side of the fence,
astute traders climb over the fence and position themselves on exactly the
opposite side. Standing huddled as a group, the journalists look at the lone trader
through the rungs of the fence with smug expressions on their faces. In a very
short period of time, however, the trader will be the only one with reason to
exhibit any smugness once the markets change direction to his or her advantage
and in exactly the opposite direction to the predictions of journalists.

Advertisers
Take a look at a major business newspaper one day and see how many ads you
can find for certain individual investment opportunities, such as real
estate, commodities or certain types of equities. Chances are you will find
several ads touting the investment potential of one particular investment or
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another. When you notice, for example, a large number of ads for the potential
for appreciation in the price of gold, the price of gold is likely to be near its top.
When the advertisers get together to scream "buy," the astute trader walks very
quickly to his or her terminal in order to hit the sell button.

The Bottom Line

Trading contrary to opinion is deadly effective because of the often-
misunderstood axiom that much of living is based on the power of paradox. At
the surface, many aspects of life and of investing, like the power of consensus
trends, appear to be true and straightforward. However, as we have seen, the
herd is almost always wrong, or at least late in jumping on the bandwagon. As
we see time and again, both in the markets and in life in general, when the herd
finally jumps aboard a trend, that trend has very nearly run its course.
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Leading Indicators Of
Behavioral Finance
Modern finance relies on two key assumptions: a rational homo sapien and a "fair
price" being determined by financial markets. Behavioral finance does not serve
as a contradiction to these tenets, but complements them by emphasizing the
importance of human psychology and groupthink in financial markets. Behavioral
finance points to the existence of market bubbles and manias as examples of
cases where human behavior may be the missing link that explains such market
anomalies. In this article we'll consider two leading behavioral indicators. (To
read more on behavioral finance, see Taking A Chance On Behavioral
Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)

Search for Reliable Indicators

Many people assume that it should be fairly easy to outperform the market simply
by replicating the strategies used by successful professionals and/or taking the
opposite position held by the "losers". Unfortunately, successful investors are
very good at hiding their true strategies, which could quickly become worthless if
replicated. On the other hand, the behavior of the "losers" or the "crowd" can be
easily observed by taking note of certain leading behavioral indicators (the odd
lot theory, for example). These indicators show that the "crowd" can be reliably
wrong at important market junctures as people fall prey to the collective emotions
of fear (at market bottoms) and greed (at market tops).

Let us consider two leading indicators of investor behavior and stock prices:

1. The put-call ratio

2. The number of stocks above their 50-day moving averages (A50 for short)

In contrast to many other attempts to apply behavioral finance theories, these

two leading indicators have the virtue of being quantifiable; in other words, they
indicate the potential tipping points in human emotions. Keep in mind, however,
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that the construction of quantifiable indicators is one of the biggest challenges for
behavioral finance and all indicators should always be interpreted in a broader
context.

Put-Call Ratio
The fact that most option market positions are held over a short period (between
one and three months) indicates that, at the very least, some option buyers are
investors looking for a quick return on their money or are often just speculating.
The buyers of puts could be making a bet that the market will decline while the
purchasers of calls are hoping for an upward move. Thus, a high put-call ratio
indicates a high degree of pessimism - it suggests that more people are betting
that the market will go down than that it will go up. A low ratio, on the other hand,
implies a lot of optimism. (For further reading, see Forecasting Market Direction
With Put/Call Ratios.)

At the extremes of the put-call ratio, the opposite of what the majority expects
usually happens. As a way of explanation, a high degree of pessimism (a high
put-call ratio) usually coincides with a declining market and plenty of cash
available for investing, which can quickly lure bargain hunters back into the
market.

Let's consider the historical interaction between a 10-day moving average of the
put-call ratio and the S&P 500 Index since 2002 (Figure 1). The ratio reached
high levels (there were too many pessimists) just at the end of the bear market in
the last quarter of 2002. Since then, all peaks and valleys in the ratio correctly
forecasted the short-term market swings (except for June 2003 when investors'
sentiment shifted radically following the start of the bull market).
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Figure 1

Stocks Above Their 50-day Moving Averages

Let us consider the change in a number of stocks in New York trading above
their 50-day moving averages. The A50 is an excellent reality check that reveals
whether movements in stock prices are broadly based or supported only by a
limited number of stocks. The broadly based moves increase the probability that
the move will continue, while narrowly based moves suggest a vulnerability to a
potential reversal. This is because if the "crowd" gets increasingly excited by only
a few stocks, the rally will be built on a shaky foundation. (For more on this,
read The Madness Of Crowds and Trading Volume - Crowd Psychology.)

In case of the A50, it is crucial to identify divergences between the A50 and the
stock prices. Since 2002, there have been several instances when the A50
diverged significantly from the S&P 500 Index (Figure 2). Twice the divergence
predicted an upswing and three times it gave an advanced warning of a
forthcoming correction. (For further reading, check out Divergences, Momentum
And Rate Of Change.)
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Figure 2

Conclusion
Behavioral finance is a relatively young field that offers considerable opportunity
for informed investors. In the not-too-distant future, behavioral finance may be
formally recognized as the missing link that complements modern finance and
explains many market anomalies. Perhaps some market participants will even
wonder how it was ever possible to discuss the value of stocks without
considering the behavior of buyers and sellers.
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Understanding Investor
Behavior
By Cathy Pareto | Updated March 10, 2017 — 6:00 AM EST

When it comes to money and investing, we're not always as rational as we think
we are – which is why there's a whole field of study that explains our sometimes
strange behavior. Where do you, as an investor, fit in? Insight into the theory and
findings of behavioral financemay help you answer this question.

Behavioral Finance: Questioning the Rationality

Assumption
Much economic theory is based on the belief that individuals behave in a rational
manner and that all existing information is embedded in the investment process.
This assumption is the crux of the efficient market hypothesis.

But researchers questioning this assumption have uncovered evidence

that rational behavior is not always as prevalent as we might believe. Behavioral
finance attempts to understand and explain how human emotions influence
investors in their decision-making process. You'll be surprised at what they have
found.

The Facts
In 2001 Dalbar, a financial-services research firm, released a study entitled
"Quantitative Analysis of Investor Behavior," which concluded that average
investors fail to achieve market-index returns. It found that in the 17-year period
to December 2000, the S&P 500 returned an average of 16.29% per year, while
the typical equity investor achieved only 5.32% for the same period – a startling
9% difference!

It also found that during the same period, the average fixed-income investor
earned only a 6.08% return per year, while the long-term Government Bond
Index reaped 11.83%.
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In its 2015 version of the same publication, Dalbar again concluded that average
investors fail to achieve market-index returns. It found that "the average equity
mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%.
The broader market return was more than double the average equity mutual fund
investor’s return (13.69% vs. 5.50%)."

Average fixed income mutual funds investors also under performed – at 4.18%
under the bond market.

Why does this happen? Here are some possible explanations.

Regret Theory
Fear of regret, or simply regret theory deals with the emotional reaction people
experience after realizing they've made an error in judgment. Faced with the
prospect of selling a stock, investors become emotionally affected by the price at
which they purchased the stock.

So, they avoid selling it as a way to avoid the regret of having made a bad
investment, as well as the embarrassment of reporting a loss. We all hate to be
wrong, don't we?

What investors should really ask themselves when contemplating selling a stock
is: "What are the consequences of repeating the same purchase if this security
were already liquidated and would I invest in it again?"

If the answer is "no," it's time to sell; otherwise, the result is regret of buying a
losing stock and the regret of not selling when it became clear that a poor
investment decision was made – and a vicious cycle ensues where avoiding
regret leads to more regret.

Regret theory can also hold true for investors when they discover that a stock
they had only considered buying has increased in value. Some investors avoid
the possibility of feeling this regret by following the conventional wisdom and
buying only stocks that everyone else is buying, rationalizing their decision with
"everyone else is doing it."
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Oddly enough, many people feel much less embarrassed about losing money on
a popular stock that half the world owns than about losing money on an unknown
or unpopular stock.

Mental Accounting
Humans have a tendency to place particular events into mental compartments
and the difference between these compartments sometimes impacts our
behavior more than the events themselves.

Say, for example, you aim to catch a show at the local theater and tickets are
$20 each. When you get there you realize you've lost a $20 bill. Do you buy a
$20 ticket for the show anyway?

Behavior finance has found that roughly 88% of people in this situation would do
so. Now, let's say you paid for the $20 ticket in advance. When you arrive at the
door, you realize your ticket is at home. Would you pay $20 to purchase another?

Only 40% of respondents would buy another. Notice, however, that in both
scenarios you're out $40: different scenarios, same amount of money, different
mental compartments. Pretty silly, huh?

An investing example of mental accounting is best illustrated by the hesitation to

sell an investment that once had monstrous gains and now has a modest gain.
During an economic boom and bull market, people get accustomed to healthy,
albeit paper, gains. When the market correction deflates investor's net worth,
they're more hesitant to sell at the smaller profit margin. They create mental
compartments for the gains they once had, causing them to wait for the return of
that gainful period.

Prospect/Loss-Aversion Theory
It doesn't take a neurosurgeon to know that people prefer a sure investment
return to an uncertain one – we want to get paid for taking on any extra risk.
That's pretty reasonable.
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Here's the strange part. Prospect theory suggests people express a different
degree of emotion towards gains than towards losses. Individuals are more
stressed by prospective losses than they are happy from equal gains.

An investment advisor won't necessarily get flooded with calls from her client
when she's reported, say, a $500,000 gain in the client's portfolio. But, you can
bet that phone will ring when it posts a $500,000 loss! A loss always appears
larger than a gain of equal size – when it goes deep into our pockets, the value of
money changes.

Prospect theory also explains why investors hold onto losing stocks: people often
take more risks to avoid losses than to realize gains. For this reason, investors
willingly remain in a risky stock position, hoping the price will bounce back.
Gamblers on a losing streak will behave in a similar fashion, doubling up bets in
a bid to recoup what's already been lost.

So, despite our rational desire to get a return for the risks we take, we tend to
value something we own higher than the price we'd normally be prepared to pay
for it.

The loss-aversion theory points to another reason why investors might choose to
hold their losers and sell their winners: they may believe that today's losers may
soon outperform today's winners. Investors often make the mistake of chasing
market action by investing in stocks or funds which garner the most attention.
Research shows that money flows into high-performance mutual funds more
rapidly than money flows out from funds that are underperforming.

Anchoring
In the absence of better or new information, investors often assume that
the market price is the correct price. People tend to place too much credence in
recent market views, opinions and events, and mistakenly extrapolate recent
trends that differ from historical, long-term averages and probabilities.

In bull markets, investment decisions are often influenced by price anchors,

which are prices deemed significant because of their closeness to recent prices.
This makes the more distant returns of the past irrelevant in investors' decisions.
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Over-/Under-Reacting
Investors get optimistic when the market goes up, assuming it will continue to do
so. Conversely, investors become extremely pessimistic during downturns. A
consequence of anchoring, or placing too much importance on recent events
while ignoring historical data, is an over- or under-reaction to market events
which results in prices falling too much on bad news and rising too much on good
news.

At the peak of optimism, investor greed moves stocks beyond their intrinsic
values. When did it become a rational decision to invest in stock with zero
earnings and thus an infinite price-to-earnings ratio (think dotcom era, circa year
2000)?

Extreme cases of over- or under-reaction to market events may lead to market

panics and crashes.

Overconfidence
People generally rate themselves as being above average in their abilities. They
also overestimate the precision of their knowledge and their knowledge relative
to others.

Many investors believe they can consistently time the market, but in reality
there's an overwhelming amount of evidence that proves otherwise.
Overconfidence results in excess trades, with trading costs denting profits.

Counterviews: Is Irrational Behavior an Anomaly?

As we mentioned earlier, behavioral finance theories directly conflict with
traditional finance academics. Each camp attempts to explain the behavior of
investors and implications of that behavior. So, who's right?

The theory that most overtly opposes behavioral finance is the efficient market
hypothesis (EMH), associated with Eugene Fama (University of Chicago) & Ken
French (MIT). Their theory that market prices efficiently incorporate all available
information depends on the premise that investors are rational.
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EMH proponents argue that events like those dealt with in behavioral finance are
just short-term anomalies, or chance results, and that over the long term these
anomalies disappear with a return to market efficiency.

Thus, there may not be enough evidence to suggest that market efficiency
should be abandoned since empirical evidence shows that markets tend to
correct themselves over the long term. In his book "Against the Gods: The
Remarkable Story of Risk" (1996), Peter Bernstein makes a good point about
what's at stake in the debate:

"While it is important to understand that the market doesn't work the way
classical models think – there is a lot of evidence of herding, the behavioral
finance concept of investors irrationally following the same course of action – but
I don't know what you can do with that information to manage money. I remain
unconvinced anyone is consistently making money out of it."

The Bottom Line

Behavioral finance certainly reflects some of the attitudes embedded in the
investment system. Behaviorists will argue that investors often behave
irrationally, producing inefficient markets and mispriced securities – not to
mention opportunities to make money.

That may be true for an instant, but consistently uncovering these inefficiencies is
a challenge. Questions remain over whether these behavioral finance theories
can be used to manage your money effectively and economically.

That said, investors can be their own worst enemies. Trying to out-guess the
market doesn't pay off over the long term. In fact, it often results in quirky,
irrational behavior, not to mention a dent in your wealth.

Implementing a strategy that is well thought out and sticking to it may help you
avoid many of these common investing mistakes.