Behavioral Finance: Investor Psychology in the Stock Market
Behavioral finance addresses how the behaviors of individuals affect the stock market. How you and I are not rational beings, but instead irrational. It deals with our biases, our blind spots, and our inherent weaknesses. But if understood, can put you ahead of most people investing in the market today.
Human behavour has always affected the stock market, but only recently has it been acknowledged. Previously, Wall Street came up with modern portfolio theory, which claimed the market is always rational, and that the price presented in a stock perfectly represents the fair value for that business. Meaning someone could only outperform the market with good luck. However, as we’ve all seen, there are people who do out-perform the market, maybe not every year, but they do consistently over a sum of years. Just as there are people acting irrationally in the stock market.
Understanding your own and the markets irrationality can save you from some very large financial mistakes.
We see this most evidently in bubbles, which happen all the time, and are always filled with a non-logical type of optimism. Non-logical in the sense the math often doesn’t add up, and the risk/reward profile of the investment often doesn’t make sense (too much downside risk) or is impossible to quantify (more than usual).
However, these investments are often filled with exciting stories, big promises, and a successful price history (until the implosion). They may make you quick money and they also make great dinner conversation. However, ask yourself the question – “if everyone thinks this is a good deal, can it be? If everyone is buying now, who is buying afterwards? How can this equate to more buying vs. selling going forward?”
An example, Tilray, a cannabis focused pharmaceutical company, IPO’d at $17 a share in July 2018 before reaching a high of $214 in September 2018, two months later, and inevitably crashing back down. At its peak Tilray had a market cap of over $20 billion USD, and Molson Coors (TAP), one of the largest beer companies in the world which had a market cap of $12.5 billion USD. Does any of this make sense?
Biases in Investing
Mania’s, and their inverse, extract the worst from humans’ biases. These are the human preconditions that stray us from the truth. These are our errors in judgement, the emotionality that makes us human. These are the cognitive errors that often show up in the stock market:
- Confirmation Bias
- Loss aversion / endowment affect
- Oversimplification tendency
- Hindsight Bias
- Groupthink
- Availability
- Representiveness
- Anchoring
- Simulation
Mr. Market
Mr. Market was written about in the Intelligent Investor by Benjamin Graham and, along with the chapter of margin of safety, is the most famous of the chapters in the often-quoted novel.
Benjamin Graham asks you to imagine Mr. Market as your business partner, an individual who offers to buy your shares everyday or sell you his. Mr. Market himself is a very emotional being, who can quickly become overly optimistic or pessimistic about the business.
It’s an important analogy because it reminds us of a few things:
- Patience – We have the opportunity to purchase shares, and can wait until these shares are bring offered in a range we are comfortable with. No one is forcing us to enter/exit the market.
- The emotional variance in the market can be an opportunity, but only if its not your curse. There are those who benefit from market irrationalities and those who fall victim to it.
- That Mr. Market is, more often than not, offering you shares that a relatively efficient price. It is only sometimes that his emotions get the best of him.
