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In the investment world there is one simple question which garners multiple complex answers; what is the economy and how does it work? More often than not, the answer one receives to this question depends largely on who they are asking. Classical Economists like Adam Smith, or John Stuart Mill, would likely reply that the economy is a system of trade and currency with constantly evolving supply which creates its own demand. Proponents of Keynesian Economics would obviously disagree.

If one was to ask this question of their high school economics teacher, the response would be one that regurgitates the simplest of academic curriculum. It would go something like this; the economy is a system of goods and services that are bought and sold, bound by natural resources, labor, and capital. But this answer, like so many others, manages somehow to be both ambiguous and vague. It manages to be both right and wrong. It is, in essence, not much of an answer at all.

The problem with Classical Economics, Keynesian Economics, and the latest high school curriculum, is that in the space between creating the theory, and publishing the theory, the theory itself becomes one more of historical relevance than one worthy of practical application. Don't get me wrong; I am not contending that Adam Smith, John Stuart Mill, John Maynard Keynes, or your favorite high school teacher were incorrect. I am simply saying that their theories aren't necessarily helping you today.

It is my contention, that if you want to employ an understanding of the economy and its conducts which can help you to invest smarter, more efficiently, and with greater reward, then you should commit yourself to a better understanding of Behavioral Economics.

What is Behavioral Economics?

The textbook definition of Behavioral Economics is long, complicated, and subjective. Rather than overwhelming you with a drawn out, academic explanation that will struggle to keep your interest and fail to help your portfolio, this article intends instead to answer this question in a way relevant to the "average investor".

Behavioral Economics is a field of study which attempts to define why markets act the way they do and why investors and consumers react to the market the way they do. It isn't as much about supply and demand as it is why the demand exists for a given supply and why the investor or consumer values that supply. Behavioral Economists believe that the economy is a living, breathing, constantly changing organism that can react positively or negatively to its environment, its people, its localized companies, and its global industry.

Why is Behavioral Economics Important?

Imagine for a moment that you have a son who is continuously getting into fights at school. He is coming home regularly with cuts, bruises, and injuries that require medical care. What would you determine is more important? Would it be continuing to get the injuries repaired and treated, or would it be finding out why your son is constantly getting into fights? After all, if you can figure out why he is behaving the way he is then you could prevent it from happening in the future.

That is the objective of the Behavioral Economist; to understand, prevent, and predict. In other words, one strives to understand where their investments are vulnerable, prevent those vulnerabilities from translating into losses, and predict where their investments are headed. If the "average investor" could do that, they would no longer be just average.

Behavioral Economics is important because in a capitalist economy, aspiring to be a true free market, the prospect of financial reward is countered equally only by the risk of financial loss. Therefore, if an investor could think more like the market behaves, and become more proactive that reactive, not only would their potential for losses be reduced, but their probability of profit would be increased.

What are the Risks of Ignoring Behavioral Economics?

On the 21st of October former Chairman of the Federal Reserve Board, Alan Greenspan, appeared on The Daily Show in an effort to promote his new book. He made an interesting point of commentary when speaking about the recent financial crisis.

"It's very interesting when you're in the financial business to try to figure out why markets behave as they do. But it's tough. A lot of people think they can do it very easily, but we really can't forecast all that well. We pretend that we can, but we really can't. Markets do really weird things because it reacts to the way people behave, and sometimes people are a little screwy".

That statement alone encompasses much of what it is to be a Behavioral Economist. If the markets do in fact react to the way people behave, then that means that as people change, the market changes. Therefore, while Adam Smith and John Keynes may have been quite right in their time, the classical approaches to understanding markets and the economy have changed as people and social habits have evolved. As people, civilizations, expectations, technology, and social habits change, so do the markets.

Mr. Greenspan went on to say:

"As analysts, we always thought that the screwiness would wash out, and that all we needed to do was look at the real numbers and the real world and that was wrong……..the simple premise that we all made was that people would act rationally in their long-term self-interest (and that) made a huge impact on how you viewed how the economy was functioning………back in 1970, the New York Stock Exchange said that broker-dealers could incorporate, prior to that they were all partnerships…….and your partner never let you take any risks that could affect them…….they wouldn't lend you a nickel overnight, and the system worked. As soon as it went to corporations they all took risks".

The interview went on, and as it did, there was one constant underlying theme; people have changed, the system has changed, and risk coupled with recklessness has changed the economy. The bottom line was that long term self-interest was overlooked for short term revenues and quick trades for big money. In other words, traditional investment practices and long understood definitions of the economy were falling by the wayside.

It makes a lot of sense if one views the economy as a mirror image of its residents.

Over the last three decades, the field of behavioral finance has blended elements of neurology, psychology, sociology, and economics. Over the last two decades the field has added technology as a major consideration as well. It has concluded without much resistance that the "millennial generation", those born from 1980 onward, are not only having the largest impact on the economy post-recession, but also that the markets have begun to reflect the personality of that generation.

That generation has largely seen behaviors such as impatience, entitlement, and narcissism define it thus far. That isn't to say those attributes represent everyone from that generation, nor does it mean that they won't change into their 30's and 40's, but right now the markets you invest in are a reflection of that generation. Most of that generation never cracked open an encyclopedia in order to study for an exam. Instead, they had all they needed on the laptop in their room. Most of them never wait to watch their favorite television shows on the night they air. Instead, they simply watch them on-demand, or online. They have been raised to expect everything right away and on their own time. To not see the correlation between that mindset and the increase of short interest in the markets over the last five years would be to ignore the obvious.

The point is that if one ignores the evolving behaviors of an emerging generation without weighing the affects that generation has on the marketplace, the economy, and one's individual investments then you are ignoring a major factor which is influencing your investments and your future.

What Can You Do?

The first thing you must do is define your individual objectives. If you are assuming a position in any equity ask yourself what you hope to gain from it? Are you in it for a quick trade at short interest? Are you looking for long term growth? Are you anticipating aggressive dividends to help you in retirement? All of these objectives are not only different, but they also qualify themselves by different criteria.

Historically, and still applicable today, is that the equities market, over time, is inevitably driven by growth and earnings. So, if you are assuming a long position in a stock then the company's fundamentals and product are most important. If you are assuming a short interest in a stock then the company's potential and short term catalysts are most relevant. If you are seeking to benefit from dividends, then obviously a company's revenues, stability, and track record will assume priority in your analysis.

Under this same matter of defining your objectives though is definition of what "short term" or "long term" interest is to you. Some people define short term interest as 30 hours, others as 30 days, and some as 30 weeks. Some people define a long term interest as three months, three years, or three decades. No matter how you define it, you must ensure that the position you are assuming in any given equity is congruent with both the timeline of yourself and the company you are purchasing interest in.

Secondly, you must beware of overconfidence. By my estimation, this is the biggest threat to an individual's portfolio. Overconfidence permeates the ranks of investors, especially among men. In fact, in a study conducted at the University of California at Davis, looking at 35,000 households over five years who actively invested, men traded at an average of 67% more often than women due to their belief that they could "beat the system" or "outperform the market". The end result of this activity was that over five years the men's portfolios underperformed the women by 7%.

This isn't groundbreaking stuff. After all, if you sat 100 people in a room and asked them to rank their driving ability you would likely be hard sought to find even a handful of people who define themselves to be below average drivers. Human beings are hardwired to expect success and to regard themselves as above average. It is in our nature. However, that kind of hubris can be detrimental to portfolio performance.

I would even go so far as to consider the following; if women are in fact less likely to assume short interest and to trade with less frequency, would it be worthwhile for long investors to consider investing in female dominated companies, which produce female related services or products, and are therefore more likely to maintain an investor base that is potentially composed of a female majority? After all, most "average investors" tend to invest in products or companies that they know, use, or believe in. Therefore, it stands to reason that companies who serve a principally female client base would retain a majority of female investors, and therefore could offer a less volatile option for long term investors.

Thirdly, beware of chasing momentum or following the crowd. Psychologically investors are often drawn to companies for the same reason young children tend to fight over toys; because other people want them. The biggest and most obvious problem with this strategy is that buying stocks when their popular, or immediately after a short term catalyst, is that they tend to be expensive and susceptible to falling as quickly as they moved upward. After all, a short term catalyst has short term affects.

In order to avoid this, abide by the Jim Cramer philosophy, that you should know the stocks you own inside and out. Before you buy a stock, do your own research and due diligence, know the company's most intricate details. After all, you wouldn't get married to someone just because your friend likes them would you? Before you assume any position in any company make sure you know that company as well as you knew your spouse before you proposed.

In truth, if you are one to chase momentum, then at least do it the right way. If you must chase, run from the rear. In other words, stocks tend to go up quickly as a result of a short term catalyst, and then fall shortly thereafter to a point even lower than pre-catalyst. This happens more often than not. So, if you see momentum that excites you, do the applicable research, get to know the company, and buy it after the post-catalyst drop.

Lastly, don't be afraid to admit defeat. Savvy investors sell losing stocks in order to book tax losses or offset gains. As logical as this may seem, many investors are unwilling to admit defeat. It is, once again, that overconfidence or ego rearing its ugly head. Investors are generally prideful, and therefore hold onto losses for inordinate amounts of time in order to "prove they had it right". This is the same motivating factor behind investors who sell early, only to criticize the stock later out of resentment if the upward trend in that equity continues. Pride and resentment are, after all, in the same category of behavioral construct.

Conclusion

If you've ever been to the horse track than you undoubtedly know someone who claims to "have a system". Ironically, the guy with "the system" is usually the one with torn canvas shoes and tattered pants. You know why? It's a result of overconfidence and desperation. That guy is more interested in proving that his system works than he is with winning. He would rather hold on firmly to what he believes, until he is proven right, than he would admit he isn't omniscient and move on. He's the saddest guy at the track.

Overconfidence, impatience, resentment, entitlement, insecurity; these are all human elements that are prevalent in the behavior of the market as well. The market reflects its people, and people reflect the market. The economy and the social construct are two sides of the same coin. Like Alan Greenspan said during his book promotion, the biggest mistake analysts made was expecting individual investors to act rationally and in their long term interest with an aversion to risk. This new market, like this new generation of investors, is impatient, volatile, and almost disregarding of risk. For many, their overconfidence translates to invincibility, and before they know it, they are leveraged to their ears, trading on margin, and shopping online for yachts and sports cars. These are the people you share investments with. This is the market you are trying to navigate. It's quick, it's fast, and it's prone to change at any moment.

I'm not suggesting that everyone just buy index funds, sit on their couch, and call it a day. However, I am imploring all investors to consider more than just numbers on a page, lines on a screen, or momentum. Assuming the market does behave with anthropomorphic qualities then we must start to consider it like any social organism. The market can get sick. The market can get depressed. It can be influenced by greed, desperation, or promise. It is not entirely what it appears to be on a good day, nor is it entirely what it appears to be on a bad day. It is, in realty, a combination of all its days and all its elements. The companies you invest in function the same way. Much like children behave like their parents, and pets behave like their owners, companies behave like their management and their investors.

Behavioral Economists believe that if you can define why a company or a stock behaves a certain way, then you are best prepared to react to it. So know the companies you invest in to the best of your ability. Follow the behavior of the stock price, the management, and the institutional investors in the same way you would follow the behavior of your children and react accordingly. Don't just read the stock quotes every day, read the social, political, and financial news of the municipalities where your investments operate.

There is no such thing as a crystal ball. Correct forecasts of upcoming events are the result of luck, research, and preparation. With people, the best indicator of future behavior is past behavior. The market as a whole is similar. Know your companies. Know your markets. Know yourself. Your instincts and insights into behavior have helped you navigate the obstacles of family, relationships, and careers. Don't be too quick to discount those same behavioral instincts and tendencies when analyzing the market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Much of the perspective and analysis detailed herein is a reflection of my own experience, education, and opinion. All details and items which required reference or sourcing have been accounted for to the best of my knowledge.

Source: Breaking The Habit: How Understanding Behavioral Economics Can Help Your Portfolio