Behavioral finance should be a part of every investor’s education. Understanding how widespread are traits such as overconfidence, hindsight bias, and frame dependence is helpful if we are to avoid their traps.
Many books are now available that cover this material. For the best introduction to this field, I’d recommend Daniel Kahneman’s Thinking, Fast and Slow or, if you can get hold of a copy at a reasonable price, Scott Plous’ The Psychology and Judgment of Decision Making.
These offer good overviews of what is known about human decision-making, the way that our minds actually work and the biases that this can create in our choices. What’s much harder to find is a really good description of how those findings can be used in practice to improve investment processes.
It’s important to avoid the temptation to think of behavioral finance as a way to unlock the secret of beating the market. Instead, think of it as a way to improve your own behavior.
We are all prone to the same inclinations: the temptation to bail at the bottom of the market, the need for a justification when we are wrong, and so on. The ability to see those tendencies in ourselves can help us to step outside them and to prevent us from taking harmful actions.
But if everybody is prone to these tendencies, doesn’t that mean that we can take advantage of the harmful actions of others? Shouldn’t behavioral finance open up a path to superior returns not just by correcting your own behavior, but also by taking advantage of the behavior of others? I’d argue that the answer to that is “no”, or at most a very qualified “perhaps.”
That’s because market behavior is not simply a straightforward mapping of individual behavior. Markets are complex systems driven by the interaction of millions of individuals who do not all follow the same rules. “More is different” as Philip Anderson put it more than forty years ago – an idea to which Michael Mauboussin devotes a chapter of his book Think Twice: “If you want to understand an ant colony, don’t ask an ant. It doesn’t know what’s going on. Study the colony.” Again (this one from a developer who built a Google Glass game based on the idea): “Ants are dumb; ant colonies are smart. The intelligence of ant behavior emerges from how the ants interact with one another, not from the intelligence of the ants themselves.” Markets are like that too.
So while it’s true that understanding the market requires a recognition of what really drives actual investor behavior (and no investor is the rational man of classical economics), that’s just one part of a very complex puzzle. That’s why behavioral finance should not be thought of as an easy key for unlocking the secrets of the market.
But it does tell us a lot about our own behavior, and why we sometimes need protection from ourselves. That’s where the first lessons lie.