(exerpt from The Only Three Questions That Count, Ken Fisher, 2007)

Behavioral Finance

Behavioral finance is a recent field of study intersecting the fields of finance and human behavioral psychology. Advocates strive to expand our exisitng knowledge of how markets work, but more important, how our minds work in relation to risk and markets. Until recently, the study of finance focused primarily on tools of investing including statistics, history, theory, and market mechanics. Does category X typically generate higher or lower returns than category Y? How should a portfolio theoretically be constructed? What is the right way to think of diversification? How do indexes like this compare to indexes like that? What is the best measure of volatility? For mean variance optimization schemes, should we use variance or covariance? These are great but basically all issues of mechanics, history, statistics, and theory in one form or another.

Scholarly finance textbooks written in the 1990s don’t differ much from those written in the 1970s. They address new technology, regulations, and products, sure, but they are mainly about the tools of investing. Traditional finance notions derive from traditional notions of economics– that humans in aggregate act rationally, markets are efficient or at least semi-efficient, and individuals acting irrationally can be ignored. The nut-job in the straight jacket has been identified and locked away and doesn’t impact markets– in the traditional view.

I hear people asking, “Where is the smart money going?” By smart money, they mean some category like institutional– the huge pools of pension, endowment, or corporate money managed by purportedly cool and collected professionals. Hogwash. There is no such thing as categorical “smart money.” There may be such a thing as stupid money, but not smart money. There is always someone right and someone wrong on each side of a trade. Some institutions get it right while others don’t. Some professionals get it right while others don’t.

There is no category of market participant who is inherently or consistently more on the right side of the market than any other. The guy on the right side of the trade can be stupid too– just lucky and right. All investment decisions, whether it’s regarding someone’s CPF contributions this year or the latest billion added to a huge university’s endowment, are made by people. People who are held captive by eons of Stone Age hardwiring– hardwiring set up to deal with different kinds of problems than those we confront with investing.

If we can understand why people behave as they do, we can understand how markets work and bet better based on what we know about human behavior. If you can understand your brain better, you can understand how to better control yourself so you can begin avoiding many of the typical mistakes investors make and begin lowering your error rate. For this, you need Question Three. Before you take any market action, you must stop and ask, “What the heck is my brain doing to mess me up? To make me blind now? To make me see and feel the situation exactly wrong and backwards?”

After all, the market is nothing more than millions of people behaving like, well, cavemen in Mercedes with BlackBerries. If you can unravel this code and understand your own decision making process better, you can conquer your caveman brain and deal with the great humiliator without being humiliated– that is the goal.

It’s not your fault your brain suffers cavemanisms. Our minds are conditioned to biases making you do dumb things that seem really smart at the time. Questions One (What do you believe that is actually false?) and Two (What can you fathom that others find unfathomable?) are intended to give you a framework for finding gameable bets. But those two questions are nothing if your brain runs ruinous. Hence, you need Question Three.

At one level, you’re very, very smart. Your brain is an amazing pattern recognizer if information is fed to it even partly correct. If information is fed to it incorrectly, you can’t see a pattern at all. Here is an example from a goofy e-mail I got:

fi yuo cna raed tihs, yuo hvae a sgtrane mnid too. Cna yuo raed tihs?

i cdnuold blveiee taht I cluod aulaclty uesdnatnrd waht I was rdaneig. The phaonmneal pweor of the hmuan mnid! It dseno’t mtaetr in waht oerdr the ltteres in a orod are, the olny iproamtnt tihng is taht the frsit and lsat ltteer be in the ighit pclae. The rset can be a toatl mses and you can sitll raed it whotuit a pboerlm. Azanmig huh? yaeh and I awlyas tghuhot slpeling was ipmorantt!

Kind of makes you wonder why you went to school, right? And kind of makes you wonder why we have editors. But it’s a perfect “eaxpmle” of your brain being able to receive information well if deliverred well. In this case you don’t even need it to be all that well delivered to be able to get it pretty easily. But often, if correct information is delivered exactly wrong, you can’t see it at all. Our earlier P/E examples are perfect in this regard. Maybe you’ve struggled with P/Es forever without them making much sense to you. A P/E of 8 is a 12.5% return, which beats the heck out of a 6% pre-tax bond. Your brain gets that easily. The issue is knowing when your brain sees well and when it’s actually hurting your ability to see reality.
Credits: This article is extracted, with modifications from The Only Three Questions That Count by Ken Fisher (Wiley Finance, 2007).