Wednesday, April 14, 2010

Behavioral Finance

 It’s clear that people generally succeed due to their behavior. There may be various degrees of success depending on their endeavor. For instance, investing in the stock market is often a losing venture as the average person trades too frequently. This results in high transaction costs as well as the tendency to buy high and sell low. This is the insight from behavioral economic research. Another flaw is overconfidence where average people think that they know more than the ‘market’ and so they can pick good stocks. These are all behavioral flaws that often result in losses in the stock market.

Observers make the conclusion that the average person cannot beat the market. This results in market ‘inefficiency’ wherein the professional investor like Warren Buffet exploits. This effort some people say result in an efficient market where equilibrium is achieved with the interplay between prey and predator. It’s not a convincing argument as studies have shown that stock are volatile and a stock’s true value will only come about after some time. Hence, the market is not efficient despite the efforts of professional investors.

Stock volatility cannot be attributed to new information about the stock such as dividends or company earnings or other new information.So a person’s behavior is the determinant of his success in the stock market. It is not a question of intelligence or stock expertise but his ability to be ‘rational’ without being influenced by market ‘noise’. Rational behavior is rewarded with the fact that market prices rise over time. In fact it does not matter what stock one would pick.

Throwing a dart or flipping a coin is also a feasible method in choosing a good stock. It’s because the market is ‘efficient’ since it’s a reflection of the mood of the millions of investors who are speculating in the market. The ‘wisdom of the crowd’ results in a random walk through an efficient arena. The constant rise of market prices over the long term can also be explained by the ‘irrational’ behavior of investors.

What does it mean? Random walk means prices are unpredictable and cannot be forecast because the market is efficient. Non-random walk means prices are predictable (for ‘value’ stocks with low P/E ratios) and inefficient which allow professional investors to exploit. So buying individual stocks does indicate that one does not believe in the random walk. On the other hand, buying index funds indicates that one believe in random walk because one cannot really spot the best stock to buy. In both situations, the underlying belief is that stock prices will rise over the long term.

Success can be achieved if one can control his behavior and hold these stocks for at least 10 years. Hence, it does not matter whether one believes in the efficient market or not if one will invest for the long run following a buy and hold strategy. The key behavior that must be cultivated is actually not related to investing. It is savings. This is the key ingredient in order to have money to invest. In order to save, one must cultivate a thrifty behavior where one does not spend to his heart’s desire and live a simple and frugal lifestyle. Maybe this is the key ingredient or behavior that makes legendary investors. As the saying goes, one’s lifestyle will portray whether one succeeds or not in his activities.


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