4 Ways To Use Behavioral Finance To Pick Better Stocks

Includes: BAC, SIRI, XLF
by: Efficient Alpha

By Joseph Hogue

Behavioral Finance is not a new concept; there have been studies as far back as the early seventies, but it is still a very much overlooked field for most investors. Traditional finance says we are all rational investors, analytically seeking the highest return for the lowest risk. This is true to a point. Behavioral finance states that given that we are about one chromosome removed from the apes and some of us seemingly less than that, our emotions often drive financial and investment decisions. Studying market cycles and prices, a strong case can be made for using some of the theories within behavioral finance to help make investment decisions. Below are five of the most studied and what they mean for your portfolio.

Overconfidence is the irrational belief that the investor is significantly more adept at analyzing the market or specific assets than other investors. When surveyed, most investors will say they have an above average ability in investment analysis, while at most only fifty percent could be correct at any one moment. Overconfidence most affects those without a clear set of rules. Unfortunately, it seems that the more time an investor spends studying the market, the more they are at risk of overconfidence.

The investor ends up relying on supposed intuition rather than solid analysis. The behavior often leads to overtrading, due to trading on gut feelings. Even if the investor has an above average ability to trade, profits are often lost to increased taxes and trading fees. One of the best ways to avoid overconfidence is analyzing your own investments or trades. Investors will often analyze only those investments that returned losses and chalk the winning trades up to skill. By carefully and objectively analyzing all trades, the investor can better understand their own strengths and weaknesses.

Anchoring is the inability to fully incorporate all new information because the investor has already conducted analysis and has a discrete opinion. The investor becomes “anchored” in their opinion of the asset and largely disregards any new advice. Even when the new information is incorporated, it is often given less weight in the overall analysis. Anchoring most often leads to surprises because the investor has failed to watch market signals and the evolution of the environment.

Many investors in Bank of America (BAC) have been surprised by the bank’s underperformance relative to the market over the last year. Towards the end of 2009, investors saw that the bank was not going to be the next Lehman and set expectations for the company. Over the last year, many have failed to incorporate new information about the size of the bank’s liabilities to mortgage litigation. Anchoring is best avoided by establishing at least some quantitative analysis within the investment decision. As economic data is released, such as retail sales, the analyst can objectively reassess the value of the holdings within the portfolio.

Confirmation bias is blocking information contrary to a belief or only seeking that information that supports the investor’s previous opinion. This is an easy one for investors because there is enough analysis and opinion on the internet alone to support any view. There’s no better example of confirmation bias than with Sirius XM Radio (SIRI). Of the six analyst opinions released for the stock over the last year, half were upgrades and half were downgrades. Fortunately, this is also one of the easier behaviors to confront. By actively seeking a contrarian view to the current opinion, the investor can better understand the risks to their investments.

Loss aversion is holding a losing investment longer than appropriate or increasing the level of risk in the portfolio due to a loss. The behavior is most easily seen in gamblers. Given $100 dollars of winnings, a player may walk away from the table hoping to take the money and run. Given losses, however, the roulette player will put more money on the table in the hopes of breaking even. Even as an investment’s fundamentals change for the worse, many investors will deposit more money, hoping to win big on the rebound. In a rising or break-even market, the investor would not take on the added risk but losses can cloud the judgment.

For investors, there is a time when doubling-down or dollar-cost averaging may be appropriate, but do not add to a position simply because it will bring your average cost down and you will have lost less on a per share basis. The best way to decide whether you should put more money towards an investment after it has suffered losses or should cash out of a bad investment is to diligently watch for the other behaviors listed in the article, especially anchoring and confirmation bias. If, after a careful analysis, the asset still looks like a good investment then dollar-cost averaging may be appropriate.

I have recently done this with my own portfolio and have added to my exposure in the Financials Select SPDR (XLF). The fund has underperformed the general market over the last three months by about 6.7%. By applying quantitative valuation techniques to the fund’s holdings and carefully analyzing all perspectives, I decided that the fund was still a good investment for my long-term time horizon.

Caveat Lector

This one is not a behavioral finance issue, but still an important note. Consider it a freebie. If you are reading this, then you know how easy it is to get investment advice on the internet or television. Advice on the internet ranges from the carefully edited to the outright fraudulent, and that offered on some of the financial news channels is often borderline as well. Be careful when selecting your sources for analysis and try to understand the author’s motivation behind any buy or sell recommendation.

The analysts most often on television are called sell-side analysts. Their job is to convince people to buy an asset, often an asset brought to market by the investment bank department of their own firm. Their only duty of responsibility is to their employer. Additionally, some analysts are so unidirectional in their advice that they are called ‘perma-bears’ or ‘perma-bulls’. Never rely on one source alone for your investment analysis.

The best advice I can offer here, and probably the hardest to follow for the amount of time it may entail, is to buy a copy of the level II curriculum of the Chartered Financial Analyst designation. It will be a series of about five textbooks, easily found on most internet auction sites. An older edition will serve just as well as this year’s version. The level II curriculum, I believe, is the workhorse of the designation and the most analytically-based. You probably won’t need the first book, which is ethics and the code of standards by which all charterholders must abide. The other books will give you about as much as you ever wanted relating to financial analysis, quantitative methods, portfolio decisions, economics, and other portfolio management topics. You don’t necessarily have to pour over every detail, I spent about 450 hours studying to pass the level II exam, but the books are a great reference when you have an investment-related question.

Whether you have two hours or twenty hours per week to analyze your portfolio and the investments within, giving some thought to the issues above will help keep your emotions out of your portfolio. A set of policies or a plan written ahead of time will help keep you from letting sentiment into your stock picks.

Disclosure: I am long XLF.