Behavioral finance may sound like a dry topic. But I can assure you it isn’t, at least when it comes to the investment markets.
If you can identify the biases, mistakes, and irrational decisions that hamstring other investors – and avoid them yourself – then you’ll be lightyears ahead of the competition each and every time you place a trade.
So what are these toxic biases, and how can you prevent them from wrecking your portfolio? Well, it helps to start with an understanding of how behavioral finance works.
If you believe that markets are inefficient, then you likely also believe that there’s an opportunity for an active manager to outperform.
He or she should be able to extract more returns from the market by researching, computing, and working hard to find opportunities that surpass the benchmark averages, all while exposing you to reduced risk.
The trick lies in understanding a fundamental truth: Investors are human! The vast majority are therefore susceptible to making emotional, irrational, or unpredictable decisions. Active managers who use behavioral finance strive to identify and time that bad investor behavior, then capitalize on it.
For instance, while many emotional investors tend to buy and chase stocks at or near their highs, then sell all of their stocks at or near their lows, prudent managers try to do the opposite. They take advantage of dislocations and distortions to extract outsized returns.
Personally, I see four biases and mistakes that constantly lead investors astray.
The first is something I call lottery mentality. It’s something that’s usually more prevalent in smaller stocks, like biotechs.
After one of these stocks experiences a day or two of strong returns, investors buy into the company like mad. But they’re essentially buying a lottery ticket, exposing themselves to large amounts of downside risk for a binary outcome.
Consider a case where a company only has one potential drug in the pipeline. Either you’re going to lose it all, or you’re going to win big. There isn’t much of an edge. But many investors overestimate their chance of success anyway … overpay for that lottery ticket … then lose boatloads of money when things don’t work out.
Next up is representative bias. Investors start expecting stocks and trends to continue along the same trajectory indefinitely — either to the up or the down side — based on short-term patterns. Unfortunately, that means they’re ignoring the principle of mean reversion. There is such a thing as gravity for the stock market on the way up, and there is rarely such a thing as a bottomless pit on the way down.
So you have to be prepared for reversals in either direction once things get too stretched. This is one reason why over time, value stocks tend to do better than growth stocks.
Investors mistakenly project growth too far into the future based on short-term patterns, without consideration for mean reversion. That results in them paying ever-higher prices for potentially declining growth – a losing strategy that you can beat by investing in cheaper, but still fundamentally strong, stocks.
Third is availability bias. Investors tend to zero in on and process what they hear about, read about and see again and again. Commentators in the media repeatedly harp on loud, attractive news stories. So you’ll hear over and over about Amazon.com (AMZN, Rated “C”) crushing the arbitrary $1,000 price level … but not about the small, closely held, value stock that’s underfollowed by Wall Street analysts but that’s also consistently increasing its margins and profitability.
If you understand that, and make a conscious effort to find out-of-the-way gems like I do, you can prosper. In fact, two researchers by the names of Fang and Peress found in 2009 that smaller stocks, with little or no analyst coverage and no media coverage, outperformed their more widely followed counterparts by 0.65% to 1% per month. That’s highly significant and counterintuitive.
That brings us to the last toxic bias – limited attention bias. There’s just too much information out there to be able to process it all as an individual investor. There are literally thousands of stocks to choose from on any given day, and most investors don’t have the time or attention span to dig through them all.
All of this brings me back to the Weiss Ratings model, and my new Weiss Ratings’ Quantum Trader service. Our firm crunches the data on more than 40,000 stocks, ETFs, and mutual funds each day. Then I take that data and use it as part of my proprietary, quantitative strategy that combines thorough fundamental and momentum analysis.
The system is designed to identify higher-rated, more-promising stocks that have started to gain investor attention — all without the biases and weaknesses I described earlier.
In sum, we’re all human and we’re all prone to making investment mistakes. But if you want to avoid the four biases I just outlined – and maximize your investment results – consider giving emotion-free strategies like mine a try. You can find out more by clicking here.
Mandeep Rai has more than 15 years of investing experience, working as both a stock and credit analyst. At Weiss Ratings, he researches and evaluates financial and economic themes, and makes decisions on when to buy or sell specific shares for the Top Stocks Under $10 portfolio.