Definition

Behavior economics is the study of psychological, social, cognitive and emotional factors that effect markets and individual actions with money.

Some Types of Biases

Below is a partial list of biases that cloud thinking and can lead to irrational actions.

1)   Loss Aversion--Losses are felt more strongly than wins. For example, losing $10 is a stronger negative emotion than winning $10 is a positive emotion.

2)  Confirmation Bias--Seeking information that validates existing beliefs.

3)   Recency Bias--Placing more weight to events that happened in the near past than events that happened in the distant past.

4)  Hindsight Bias--Pretending you could predict (or should have been able to predict) past events.

5)    Herd Mentality--Following the crowd.

6)    Mental Accounting--Viewing various sources of money as being different than others. Often exemplified by spending $150 more on eating out because you saved $75 on your cable bill.

 

tHINGS TO REMEMBER

1)  Be Ready for Anything--Anything can happen. Especially the unexpected.

2)  Diversify--Truly spread your money around. This doesn’t mean merely  owning a bunch of different stocks, as that likely won’t be good enough. Stocks tend to move up and down together. Own cash, own real estate, invest in a small business, etc....and don’t buy a bunch of stock in your employer. You already depend on them for a paycheck.

3)  Follow a Plan--Whatever method you use to invest, bad or brilliant, will likely experience times when drunken clowns could have outperformed it. If you constantly change your plan in response, you will likely lose. Lots of different methods are viable over the long term, but almost no plan works if it is changed every year.

4)  Don’t Predict--When you think about making predictions, ask yourself if you saw these things coming:

  • The rise of Steph Curry as an NBA superstar
  • Tiger Woods sudden decline
  • Johnny Manziel’s Heisman Trophy in 2012

Most investors know more about sports than investing. If you can’t successfully predict sports, you likely can’t predict with respect to investing. And if you can predict sports? You still probably can’t predict in the investing arena. There are ways to investing without predicting, it might be wise to learn them.

5)  Taxes and fees matter--Don’t forget them.

6)  Simple is better than complex--Complex is fragile. Simple is strong.

7)  Understand Mean Reversion--Mean reversion basically is a return to average. If a mediocre golfer has a hot round or two, it is unlikely that this will continue for much longer. Investments operate in a similar manner. Often investors look at the 3 and 5-year returns of stocks/funds to make a buying decision. They get in, only to see mean reversion kick in and the formerly hot stocks have middling or bad returns going forward. Note that this does not necessarily invalidate the concept of momentum, as momentum is generally based on the one year (or less) performance, when the hot streak still could have some life left in it. Understanding the nuanced relationship between mean reversion and momentum and how they don't necessarily contradict one another is critical.

 

Further study:

Behavioral economics book-The Behavior Gap by Carl Richards

Behavioral economics book Misbehaving: The Making of Behavioral Economics  by Richard Thaler

Behavioral economics book-Thinking Fast and Slow by Daniel Kahneman

Just about any book by Nassim Taleb.