Investing with an Understanding of Psychological Factors in Market changes

Does the stock market play tricks on our mind? Ever get the feeling that your in a staring match with the market and you always seem to blink first? If your like me there may be times when you look at your investment portfolio and say to your self, what was I thinking. Maybe there was a stock in your list of prospects that you were eyeing that just seemed to take off before you were able to capitalize on it’s move. Worse yet, have you experienced the nauseating feeling of watching a stock you were considering removing from your portfolio proceed to drop like a huge anvil into the stock market abiss before you were able to chuck it as far from your portfolio as humanly possible.

Investment professionals who specialize in Behavioral Finance would tell you there were reasons that the market might at times get the best of you. Behavioral Finance is the arena of study regarding the role emotion and mental errors play in equity valuation. These emotions and mental errors can lead to stocks being overvalued or undervalued by large segments of investment professionals and personal investors.

A primary main concentration of Behavioral Finance is “representativeness”, or representative conditioning. The term representativeness alludes to the brains utilization of classification shortcuts, as we process information our brain makes assumptions based upon past experiences it has undergone. Here is an example: Your driving 55 mph down the middle lane of a three lane interstate, a white 1972 Volkswagen Beatle driven by a gray haired grand motherly woman passes you on your right, a moment later a red 1972 Corvette driven by a young man passes you on your left, shortly there after a police cruiser with it’s lights flashing rushes by you. Typically many of us would assume, based upon prior experience, that the guy driving the Corvette is about to get a ticket. As the police cruiser pulls behind the Volkswagen we realize we were wrong.

In relationship to equities, investors frequently will identify companies listed in investment articles, web sites, news papers, etc. as companies that they know are bad companies, even despite recent good news related to the company we will often disregard it as a one off happenstance. We may even chuckle to our selves, “well, well look at stock abc it finally met it’s earnings expectations”, and flip the page of what ever paper, magazine, or stock screen we’re looking at. We have become conditioned to view the company as a bad investment, we may not even make an effort to look into why, all of a sudden company abc is doing well. We have conditioned ourselves to represent it as a bad company. However, companies change, managements change, industries change, sectors change and markets change. As these changes take place stocks often become undervalued or overvalued based upon our prior representative conditioning.

Similar to representative conditioning is the Behavioral Finance theory of “Anchoring”. This alludes to the dynamic whereby the brain anchors to a primary or initial orientation point and through complex problem solving exercises, adjusts from the initial orientation point to a more correct understanding based upon the additional data or information we process during problem solving. A classic example of anchoring is buying a stock an initial low purchase price and then failing to purchase more of the stock as it’s price moves up. We know we bought it at it’s initial purchase point, we feel it was a fair purchase price, however the dynamics of the company or even the company’s sector may have shifted, we anchor to our initial investment thesis and or purchase price, while the stocks moves forward never to look back.

Behavioral Finance seeks to take advantage of these human behaviors by identifying investment opportunities where investors both professional and personal have dismissed new information regarding market conditions or equity valuation. Frequently the market’s herd mentality leads to massive over reaction or under reaction to fundamental changes in individual securities or market conditions. The Behavioral Finance practitioner’s goal is to identify these companies, and to invest in them before the little old lady in the Volkswagen receives her ticket. That is, before the majority of other investors realize that their behavioral conditioning has led to their mistake.