Applying Behavioral Economics to Stock Trading

You can’t predict the market; however, you can predict people’s behavior and regulate your own. Too many investors rely on current news and price trends for buying and selling stocks. These indicators create false senses of urgency and lead to losses. This article will teach you how to apply behavioral finance and “zig while everyone zags,” resulting in gains.

Four Behavioral Economics Principles You Must Know

Investors suffer from five cognitive biases (systematic thinking errors). By understanding them, you will not only be able to anticipate their mistakes, but regulate your own emotions.

1) Availability Bias

If you only listened to news, you’d think terrorism is the number one cause of death. The media constantly covers stories on this topic, forcing us to believe it’s more prevalent than it’s true probability. According to Yuval Noah Harari, from a macro perspective, the average person is 1.4x more likely to die from diabetes than terrorism. Why then doesn’t the media cover stories on diabetes?

To increase ratings, news outlets promote stories that drive urgency and instill fear. This is why, when the average investor hears positive or negative news on Tesla, they react and buy or sell the stock immediately.

Advice: Do not react to news stories. You zig while everyone zags! When positive news about a merger surfaces, you add the stock to your watchlist and wait a few months to see how the market reacts. People forget news quickly and once they do, the price will drop and at that moment you buy the stock.

2) Hyperbolic Discounting

People are impatient and prefer smaller-sooner rewards over a larger-later reward. Take the below example:

Which of the following two options do you prefer?

  • $100 now
  • $110 a week from now

In this scenario, which option do you prefer?

  • $100 in 51 weeks
  • $110 in 52 weeks

The average person chooses to have the $100 now; however, the more time passes, she becomes indifferent. So in the second scenario, she prefers $110 in 52 weeks because she’s already waited 51 weeks.

According to Daniel Crosby, Chief Behavioral Officer at Orion Advisor Solutions, there’s a correlation between the amount of times an investor checks her portfolio and losses. This is because investors grow impatient and buy or sell at the wrong times. On any given day, the market is up about 55% of the time and down about 45% of the time. That’s an emotional rollercoaster.

Advice: Be patient and reduce the amount of times you check your portfolio. I only check it on a desktop computer instead of the mobile application where it’s easily accessible.

3) Anchoring 

Use price highs and lows as your anchors. For example, Tesla dropped from $502 per share to $329 in the first week of September 2020 (read more here). News about it being snubbed from inclusion in the S&P 500 scared investors and caused a snowball effect (also known as herding behavior).

Tesla’s operations didn’t change! Solely news and herding behavior caused the price drop which is irrational. Using $502 as an anchor for Tesla’s potential, we can see that buying it at the new price of $329 is a good buy. If you’re like me and bought at that point, you would have seen 156% gains by the middle of January 2021.

Advice: Compare current stock price to the all-time high. If there’s a big gap, it could be a buy.

4) Disposition Effect (a Form of Loss Aversion)

According to Daniel Kahneman and John Nofsinger (2005), selling a winning stock validates a good decision to purchase that stock in the first place and stimulates pride. Conversely, selling a losing stock causes the realization that the original decision to purchase it was poor, and thus stimulates regret.

People fear regret and hate loss. In fact, according to Daniel Kahneman and Amos Tverskey’s loss aversion experiments, the pain of losing is psychologically twice as powerful as the pleasure of gaining.

When an investor sells gains for the “satisfaction,” she rejects Warren Buffet’s and Peter Lynch’s advice, “let your winners run.” Lynch says, “the key is having a few big winners and letting them run for as long as possible.”

Advice: Do not sell a stock just because it gained. If it’s from a reputable company that you believe in, hold and let it run. If you need to sell it for whatever reasons, take advice from Daniel Crosby and try dollar-cost averaging (“DCA” for short). “DCA” is a simple investment strategy in which an investor splits the total amount to be invested or sold in a given asset across regular periodic purchases. The regular purchases occur regardless of price, volatility, or economic conditions.

Moreover, understanding people’s loss aversion helps anticipate changes in stock price. If a stock increases quickly, wait a bit for investor’s loss aversion to kick at which time they will sell. When the price lowers enough, buy it!

Conclusion

You can’t predict the market, but you can predict investing behavior. Leverage these four Behavioral Economics concepts: 1) availability bias; 2) hyperbolic discounting; 3) anchoring; and 4) disposition effect to improve decision-making and regulate your own emotions. Be patient and “zig while everyone zags.”

Want to know about our personal stock picks? Check out our past and current trades.

Salesperson? Learn how to apply Behavioral Economics

Sources:

Books

  • Kahneman, Daniel. Thinking, Fast and Slow
  • Harari, Yuval Noah. Sapiens (A Brief History)
  • Harari, Yuval Noah. Homo Deus: A History of Tomorrow

Website

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