February 19th, 2013

imageThe other day, Business Insider reprinted research originally written by Goldman Sachs on the topic of Behavioral Finance, a relatively new sort of financial science that investigates how biases often override the traditional, foundation principals of finance and influences our investment decisions.  I last wrote about Behavior Finance while reviewing a favorite book, Far From Random, back on December 9, 2009.  Goldman Sachs distilled the concept into a extremely easy to read and understandable schematic (click on image to enlarge):

Behavioral Finance

Is there anyone who doesn’t recognize some or all of these biases in themselves or their investment decisions; if you don’t you aren’t being totally honest with yourself.:

  • Mental accounts – unwillingness to invest in a good opportunity because you “missed out already”.
  • Confirmation bias – cherry picking data to support a thesis, rather than objectively analyzing.
  • Causal thinking – assuming a link between a news story and the share price performance that day.

How should you use this information?

  1. I would print out that schematic and past it prominently above your PC or workstation.
  2. Develop objective rules to guide your analysis and trading activity

The trading self-discipline is centered around the Market Momentum Meter to help guide my emotions when it comes to timing the market, my stock selection is based on breakouts across resistance in stock chart and my Sell Rules help me control against excessive churning and letting the winners to run (it’s spelled out in greater length in my book, Run with the Herd).  You can never totally eliminate risk but you reduce the self-imposed risks brought on by volatile emotions, faulty reasoning and illogical behavior.

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