Behavioral Finance and Trading

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How behavioral finance can help you to trade and invest better.

The financial market is a place full of emotions and irrationality. It’s easy to fall into its numerous traps and lose money. The behavioral finance can help you to avoid these traps, especially those set by yourself – it’s unbelievable, but you are the worst enemy you’ll find over here.

The behavioral finance is a relatively new field on science, but it already had such a huge impact on our society. Although Adam Smith theorized a lot of things almost 300 years ago in his book “The Theory of Moral Sentiments”, just recently we were able to do a scientific approach to our behaviors and emotions and figure out exactly how they influence our lives.

Just as I said in this post, technical analysis is a good tool to understand the market. The candlesticks and the Dow Theory were developed to help you to understand the market psychology. The behavioral finance is similar, but with one difference – it helps you to understand yourself.

As traders and investors (and humans!), we are victims of a series of heuristics and biases that will get in our way and will prevent us from earn money. Here, we are going to discuss about some of the most common heuristics and biases that affects us regarding trading and investing.

1 – Confirmation Bias:

This is one of the most common bias I find around the market. People are always trying to trade what they want to see, rather than what is happening. We all have our expectations, and often we pursue only the information that confirm our previous believes, just to make ourselves feel better.

How to overcome this bias? Just force yourself out of your comfort zone and go look for more information that confronts your beliefs. It will get easier to do this with time but requires some discipline.

2 – Herding Mentality:

This one is very funny. For evolutionary purposes, we are driven to do whatever the group does. If everyone is buying certain stock, then it’s wise to buy it, right? It must mean something good. And this is how traders and investor buy at the top, and sell at the low, when their loses starts to hurt them.

Instead of studying, or searching for good information, they will simply copy what others are doing. And how to avoid this? You must have a solid plan, and a good trading methodology. You should have tools to help you to invest and trade, and only by using them you will be able to think straight.

The fundamental analysis can tell you if a certain stock is worth of buying, and the technical analysis can help you to decide the best moment to buy it.

3 – Hindsight Bias:

Real trading is reactive, not predictive, and there’s a reason for that – we can’t predict the future. We may have our expectations, yes, but never trade or invest on them. The hindsight bias is the responsible for anyone to say the famous “I knew it”.

I’m sorry to tell, but no, you didn’t know. This is something I’m always trying to pass to my students. We just react to what is happening, but we are not trying to predict anything. Even when we were right, it doesn’t mean we knew what was about to happen – just means the market behaved according to the odds at that moment.

4 – Self-serving Bias:

This bias is interesting, because it is highly correlated with another bias, the Overconfidence Bias. We all have the tendency of believing that our skills are better than the average, and that makes us overconfident. But it may get even deeper, to the point where you will attribute your loses just to lack of luck, and your gains on your prowess – this is the Self-serving Bias.

Traders and investors should courageously bear the brunt of our decisions – this is our responsibility and a duty to ourselves. We would never seek more knowledge, study more or work harder if we don’t admit that we are flawed. As I said, the behavioral finance reveals that our worst enemy is inside each one of us.

How to avoid this bias? Well, it’s hard, but just stick to your trading methodology, and always be humble enough to admit that you still have a lot learn. We must always be willing to learn more each day.

5 – Loss Aversion:

Probably, the most dangerous bias, and it deserves a full post about it. In the financial market, this bias is particularly dangerous because when you buy a stock, and it drops, technically you will only lose your money if you sell it, correct?

And this is why most of traders will sell quickly a stock that it’s giving them some profits (because they want to earn money so badly), but they will keep the stocks that are causing loses (because they don’t want to lose money).

What is interesting is that in theory, this is bias is easy to avoid. You should just have a trading methodology and stick to it. Have a trading plan, know when you will trade, when you’ll exit, and do a good risk management. But this is just in theory.

CONCLUSION

Trading and investing requires discipline, and since it’s such an easy thing to do – you can just open an account and start trading – is easy to lose money too. The greatest traders and investors I know spend most of their time studying and preparing themselves to trade in the market.

This is another lesson I always try to pass to my students – patience. The ability to just stay quit and watch the market is a life-saver skill. Before trying to earn money in the market, we must know ourselves first.