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 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.

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.

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.

To continue reading on behavior-based trading, see Trading Psychology: Consensus Indicators - Part 1, Leading Indicators Of Behavioral Finance, Understanding Investor Behavior and The Madness Of Crowds.

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