Investors are constantly looking for an edge when investing money that will boost their performance in relation to other investors and the market as a whole. Behavioral analysis is one discipline that offers broad scope for research designed to enable improved investor performance. The reason for this is obvious: the stock market, along with other markets, reflects human economic activity. While not all human behavior is economically oriented, the drive to improve one’s financial position is a strong one – as a result, understanding its implications can only be helpful when it comes to deriving useful conclusions about how human behavior affects the stock market.
This type of analysis generally focuses on arriving at general principles that enhance your understanding of market behavior. While such knowledge is not a substitute for forming an accurate impression of a company’s or sector’s business prospects, it can prove valuable when performing what is known as technical analysis – the study of past price and volume metrics in hopes of discerning valuable trends or patterns that can prove helpful in predicting future outcomes.
While there are any number of human behavior patterns that can be studied for insight into market action, this article will focus on three of the most notable such patterns when investing money:
- Herd behavior
- Loss aversion
- Myopia (short-termism)
Herd Behavior & Investing Money
Herd behavior is easy to see in animals such as herbivores who huddle together, sometimes in tremendous numbers, for protection and companionship. When the herd moves, the vast majority of its members have no say in which way it moves, they must simply make sure to head in that direction or risk getting trampled by their fellow herd members. What does this have to do with the stock market? Think of Internet stocks in 2000, or home mortgage stocks in 2007; in both cases the valuations of stocks in these sectors in many cases had risen to ridiculous extremes. The result of such overvaluation was significant loss of capital for recent buyers of such stocks when the market crashed.
The takeaway is that humans, being mammals, are subject to the same herding impulse which is so easy to notice when observing the behavior large groups of herbivores. While it may be subtler in humans, the same type of behavior can occur in various instances such as fads, trends, and the price movements of stocks. Investors can take advantage of their knowledge of this phenomenon by staying away from excessively popular “herd” stocks which have risen far in excess of their fundamental value or, for the more adventurous, choosing to short such stocks. If you take the latter approach exercise extreme caution – shorting a popular stock can be very expensive if your timing is off.
Various studies have shown that, generally speaking, people are more likely to resent giving up what they already have than to forego something they don’t currently possess. What does this insight mean in regards to the markets? One area where such behavior can be observed is in the interplay between taxes and inflation in a society. When government taxes its citizens, it is clear to them that they are contributing currently owned or earned dollars. As a result, at some point governments find that raising taxes further is not feasible – politicians get voted out of office or popular unrest occurs when taxes are raised to levels that people find unbearable.
On the other hand, inflation, which doesn’t directly take money out of a person’s pocket, as long as it doesn’t get out of control, is generally not seen as a government revenue-raising program. For this reason, inflation is sometimes called a hidden tax. By debasing the currency, a government can effectively increase its portion of a society’s currency without needing to raise taxes. Thus, it should come as no surprise that modern monetary systems tend to be inflationary, especially when a crisis strikes and governments use currency printing as the “easiest” method of dealing with the crisis.
For investors, understanding this phenomenon is helpful when it comes to gauging the monetary policy likely to be followed by a country in times of financial trouble. Unless there is a strong disincentive to use currency debasement to stem the tide, such as after an episode of hyperinflation when fiscal rectitude is at a premium, investors can usually count on governments, usually through their central banks, pursuing easy money policies that boost inflation during times of financial or economic crisis. With this knowledge, investors can use investments such as precious metals which typically perform well during such periods to help protect their portfolios from the ravages of inflation.
Myopia in economic parlance doesn’t refer to a visual disorder but to the phenomenon of making decisions that may appear attractive in the short run but have bad long-term consequences. From a behavioral standpoint, the drive behind myopia of this type seems to be humankind’s evolutionary development. For the preponderance of humanity’s history, agriculture as we know it did not exist, therefore to survive people could not, for the most part, depend on easy access to stored food. Thus, the most adaptive individuals were those who could find food now, not necessarily those who could predict where food might be found a month or a year from now. Thus, the drive for immediate gratification, although less important in modern society, was a highly valued trait for much of our species’ history.
When it comes to investing, the most successful investors, by and large, pursue the opposite approach. They realize how difficult it is to predict short-term moves in the market and focus on where the market is likely to be over a longer period of time. To do this, they must identify the underlying trends that drive market moves. They must also fight the natural human inclination to focus on short-term performance. If you can successfully keep your desire to make money in the short run in check in favor of taking advantage of longer-term trends, you can gain an advantage over investors who give in to these urges and only invest based on what is hot right now. By the time these investors realize what more farsighted investors have realized, investments based on such insights often have already risen substantially in price, preventing short-term oriented investors from earning the same level of profits generated by those who were willing to invest over a longer time period.