I thought I might give a little insight into what is becoming a hot topic in the investment community. What the heck is behavioral finance? The science of economics says that people will always do what’s in their best financial interest. If the TV you want is at Sears for $300 and $290 at Best Buy, it’s off to Best Buy. The idea of behavioral finance is that people’s behavior may make them do things that looked at from a purely financial point of view, don’t make sense. If the salesperson at Sears selling that TV was a really cute gal/guy then maybe it’s off to Sears for you. Behavioral finance tries to explain some of the other forces besides economics that effect our financial decisions. There are three areas that are of interest to the investment community related to Behavioral finance.
First is client behavior. Are there behaviors that people often exhibit that aren’t rational economically? For example, if stocks have gone down dramatically, that would be a great time to buy. But fear of losing everything in a down market may cause paralysis for a client. The investment professional needs to be aware of that fear.
Second is trading volume. When markets go up, trading volume increases. When markets go down it decreases. Watching the ups and downs of the market can help organizations like brokerage firms make personnel and technology decisions based on expected business.
Third is market prediction. This is where there is keen interest. Can we use what we know about people’s behavior to make money in the stock market? There are a number of general behaviors that have been observed time and again. Things like overconfidence at market tops, the tendency of people to sell their winners and hang on to their losers, etc. This is a really cool idea. Figure out how people behave and you can predict the markets. Unfortunately coming up with anything that actually helps you make more money has been very elusive. It’s clear why. People’s behavior changes. And trying to predict how it will change… well that makes my head hurt.
While professionals debate the relative merits of behavioral finance (I’m on the advisory committee for a behavioral finance sub-group of the Los Angeles Society of Financial Analysts), I think there is something useful here for everyone. Not for how to behave, but how not to. It was clear that there was panic selling going on in the summer of 2002. Time to buy, not to sell. It was crystal clear there was a mania for internet stocks in 1999. Better to step aside. I think behavioral finance may not ever tell us anything useful about where to invest, but it may tell us how not to be dumb. And in the long run that’s probably more important.
Expect to see ‘behavioral finance’ start showing up as a popular topic over the next few years, it’s gaining a following.