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7 ways to profit from other people’s folly

This is a guest post from Tim, author of the Psy-Fi blog [1], an excellent take on psychology and finance.

Behavioural finance – the study of where psychology meets finance and a car crash ensues – is now accepted as revealing how people mismanage their investments.

The behavioural finance approach offers a very different view of the world to old-fashioned efficient market theories, which reckoned that all stock prices were correct and based on rational thinking by rational investors in a rational world.

No one who’s experienced the last decade of turmoil can really believe that markets are efficient!

On the other hand, efficient market theories have the great benefit that they can be used to create so-called quantitative models. These models work for most of the time while people behave roughly rationally, and so enable investment firms to make decent amounts of money.

Unfortunately they’re also completely useless when everything goes wrong.

Quantitative models are also one of the main reasons for the huge black hole in global finance that our taxes are being used to fill up.

So, what has behavioural finance ever done for us?

If efficient market theories are flawed, we might well ask whether behavioural finance offers a practical alternative for hard-pressed private investors.

Behavioural finance relies on the wetware between our ears, and there’ll be no real model based on it until we can effectively simulate brain chemistry and connectivity.

But while this is no good to the investment industry – which wants ways of removing people from the tricky business of making investment decisions in order to generate fat bonuses as fast as possible (preferably before the next crash) – it can help the rest of us avoid the more dangerous bear traps that investing throws at us.

Here are seven behavioural finance insights to help you to make more money:

1. There’s always a crisis around the corner

History tells us that there is a crash in some market, somewhere in the world, every decade.

To profit: We should always proceed on the basis that we may (temporarily) lose half the value of our investments tomorrow and make decisions accordingly.

2. Everyone is at it

Investment advisors, expert commentators, mutual fund operators and that well-informed bloke we met on the Internet are all affected by behavioural factors. In fact experts if anything get worse results than a monkey throwing darts at a copy of the Financial Times.

To profit: Be very careful whose advice you take because your losses are always your own.

3. Stocks tend to under-react both to good news and bad news

This is because people like to sell at a profit, so they sell stocks on good news when they should keep them, and not at a loss, so they keep stocks reporting bad news when they should sell them.

To profit: If you have to invest actively, then these trends are worth exploiting.

4. People are horribly loss adverse

Even Tiger Woods is more likely to make a par putt than a birdie — avoiding selling stocks at a loss because we want to avoid the psychological pain [2] of losing money is a dangerous policy. We also sell stocks in profit regardless of their future prospects in order to achieve the pleasure of a locked in gain.

To profit: Remember that selling winners and cutting losers for psychological reasons is profoundly irrational and usually damaging to investment returns.

5. Don’t underestimate the gullibility of investors

Companies changing their name to something Internet-related during the dotcom boom saw their share prices soar, even when their business was unrelated to technology. When the market was imploding, the reverse was true.

To profit: Don’t rely on markets for rational pricing.

6. Stay honest

We can improve our investment decisions, but only if we make sure we get good and effective feedback. Most of us don’t like facing the consequence of our decisions and avoid analysing our mistakes. This is the biggest mistake of all.

To profit: Keep an investment diary and schedule a regular review – you’ll be surprised how this changes your decision making mentality. Or try justifying your investment decisions to your partner every six months or so.

7. Don’t confuse anecdotes with evidence

We rely on stories to find our way through our lives, and a good narrative has much more neural impact than a bunch of dry numbers.

To profit: Never forget that in investment it’s the numbers that matter.

Behave yourself

Most successful investment, as Charlie Munger says, is not about being successful but about avoiding mistakes.

Unfortunately human nature means that avoiding share investing mistakes is not commonsense.

Nothing in our evolutionary history prepares us for the need to embrace the markets when blood is running in the streets and to run away when everyone else is dancing in the disco.

Yet unless we’re able to overcome our instinctive reactions, we’re simply apes hoping to follow everyone else to the next banana tree. It’s better to find our own tree and keep quiet about it.

You can read more about behavioural finance on the Psy-Fi blog [1].