Friday, October 14, 2011
An Introduction To Behavioral Finance
It's hard not to think of the stock market as a person: it has moods that can turn from irritable to euphoric; it can also react hastily one day and make amends the next. But can psychology really help us understand financial markets? Does it provide us with hands-on stock picking strategies? Behavioral finance theorists suggest that it can.
Tenets and Findings of Behavioral Finance
This field of study argues that people are not nearly as rational as traditional finance theory makes out. For investors who are curious about how emotions and biases drive share prices, behavioral finance offers some interesting descriptions and explanations.
The idea that psychology drives stock market movements flies in the face of established theories that advocate the notion that markets are efficient. Proponents of efficient market hypothesis say that any new information relevant to a company's value is quickly priced by the market through the process of arbitrage.
For anyone who has been through the Internet bubble and the subsequent crash, the efficient market theory is pretty hard to swallow. Behaviorists explain that, rather than being anomalies, irrational behavior is commonplace. In fact, researchers have regularly reproduced market behavior using very simple experiments.
Importance of Losses Versus Significance of Gains
Here is one experiment: offer someone a choice of a sure $50 or, on the flip of a coin, the possibility of winning $100 or winning nothing. Chances are the person will pocket the sure thing. Conversely, offer a choice of a sure loss of $50 or, on a flip of a coin, a loss of $100 or nothing. The person will probably take the coin toss. The chance of the coin flipping either way is equivalent for both scenarios, yet people will go for the coin toss to save themselves from loss even though the coin flip could mean an even greater loss. People tend to view the possibility of recouping a loss as more important than the possibility of greater gain.
The priority of avoiding losses holds true also for investors. Just think of Nortel Networks shareholders who watched their stock's value plummet from over $100 a share in early 2000 to less than $2. No matter how low the price drops, investors, believing that the price will eventually come back, often hold onto stocks..
The Herd Versus the Self
Herd instinct explains why people tend to imitate others. When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing.
Behavior finance has also found that investors tend to place too much worth on judgments derived from small samples of data or from single sources. For instance, investors are known to attribute skill rather than luck to an analyst that picks a winning stock.
On the other hand, investors' beliefs are not easily shaken. One belief that gripped investors through the late 1990s was that any sudden drop in the market is a good time to buy. Indeed, this view still pervades. Investors are often overconfident in their judgments and tend to pounce on a single "telling" detail rather than the more obvious average.
How Practical Is Behavioral Finance?
We can ask ourselves if these studies will help investors beat the market. After all, rational shortcomings ought to provide plenty of profitable opportunities for wise investors. In practice, however, few if any value investors are deploying behavioral principles to sort out which cheap stocks actually offer returns that can be taken to the bank. The impact of behavioral finance research still remains greater in academia than in practical money management.
While it points to numerous rational shortcomings, the field offers little in the way of solutions that make money from market manias. Robert Shiller, author of "Irrational Exuberance" (2000), showed that in the late 1990s, the market was in the thick of a bubble. But he couldn't say when it would pop. Similarly, today's behaviorists can't tell us when the market has hit bottom. They can, however, describe what it might look like.
Conclusion
The behavioralists have yet to come up with a coherent model that actually predicts the future rather than merely explains, with the benefit of hindsight, what the market did in the past. The big lesson is that theory doesn't tell people how to beat the market. Instead, it tells us that psychology causes market prices and fundamental values to diverge for a long time.
Behavioral finance offers no investment miracles, but perhaps it can help investors train themselves how to be watchful of their behavior and, in turn, avoid mistakes that will decrease their personal wealth.
It's hard not to think of the stock market as a person: it has moods that can turn from irritable to euphoric; it can also react hastily one day and make amends the next. But can psychology really help us understand financial markets? Does it provide us with hands-on stock picking strategies? Behavioral finance theorists suggest that it can.
Tenets and Findings of Behavioral Finance
This field of study argues that people are not nearly as rational as traditional finance theory makes out. For investors who are curious about how emotions and biases drive share prices, behavioral finance offers some interesting descriptions and explanations.
The idea that psychology drives stock market movements flies in the face of established theories that advocate the notion that markets are efficient. Proponents of efficient market hypothesis say that any new information relevant to a company's value is quickly priced by the market through the process of arbitrage.
For anyone who has been through the Internet bubble and the subsequent crash, the efficient market theory is pretty hard to swallow. Behaviorists explain that, rather than being anomalies, irrational behavior is commonplace. In fact, researchers have regularly reproduced market behavior using very simple experiments.
Importance of Losses Versus Significance of Gains
Here is one experiment: offer someone a choice of a sure $50 or, on the flip of a coin, the possibility of winning $100 or winning nothing. Chances are the person will pocket the sure thing. Conversely, offer a choice of a sure loss of $50 or, on a flip of a coin, a loss of $100 or nothing. The person will probably take the coin toss. The chance of the coin flipping either way is equivalent for both scenarios, yet people will go for the coin toss to save themselves from loss even though the coin flip could mean an even greater loss. People tend to view the possibility of recouping a loss as more important than the possibility of greater gain.
The priority of avoiding losses holds true also for investors. Just think of Nortel Networks shareholders who watched their stock's value plummet from over $100 a share in early 2000 to less than $2. No matter how low the price drops, investors, believing that the price will eventually come back, often hold onto stocks..
The Herd Versus the Self
Herd instinct explains why people tend to imitate others. When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing.
Behavior finance has also found that investors tend to place too much worth on judgments derived from small samples of data or from single sources. For instance, investors are known to attribute skill rather than luck to an analyst that picks a winning stock.
On the other hand, investors' beliefs are not easily shaken. One belief that gripped investors through the late 1990s was that any sudden drop in the market is a good time to buy. Indeed, this view still pervades. Investors are often overconfident in their judgments and tend to pounce on a single "telling" detail rather than the more obvious average.
How Practical Is Behavioral Finance?
We can ask ourselves if these studies will help investors beat the market. After all, rational shortcomings ought to provide plenty of profitable opportunities for wise investors. In practice, however, few if any value investors are deploying behavioral principles to sort out which cheap stocks actually offer returns that can be taken to the bank. The impact of behavioral finance research still remains greater in academia than in practical money management.
While it points to numerous rational shortcomings, the field offers little in the way of solutions that make money from market manias. Robert Shiller, author of "Irrational Exuberance" (2000), showed that in the late 1990s, the market was in the thick of a bubble. But he couldn't say when it would pop. Similarly, today's behaviorists can't tell us when the market has hit bottom. They can, however, describe what it might look like.
Conclusion
The behavioralists have yet to come up with a coherent model that actually predicts the future rather than merely explains, with the benefit of hindsight, what the market did in the past. The big lesson is that theory doesn't tell people how to beat the market. Instead, it tells us that psychology causes market prices and fundamental values to diverge for a long time.
Behavioral finance offers no investment miracles, but perhaps it can help investors train themselves how to be watchful of their behavior and, in turn, avoid mistakes that will decrease their personal wealth.
Accepting Feedback and Criticism
New traders are notorious for needing to be right. This natural, human tendency is so powerful that novice traders engage in unproductive trading behaviors to avoid admitting that they are wrong. They might hold on to a losing trade, to keep losses on paper. They may procrastinate or put off making a trade in an effort to avoid facing the consequences of a bad trading idea. In many ways, your need to be right can be stifling. A trader who consciously or unconsciously needs to be right may hold back at critical moments. If you are inhibited and afraid, you avoid making trades. Accepting feedback and criticism is fundamental for trading success.
Why is it so hard to accept criticism, whether it is from another person or the markets? One of the main reasons is that we associate criticism with inadequacy. We tend to place great psychological significance on a critical comment or negative feedback of any kind. It’s as if parents are criticizing you for doing something wrong. This is a false assumption. There is no need for criticism to have any emotional meaning. Take criticism and feedback in stride. It isn’t personal; it’s just feedback. If you can learn to downplay its emotional significance and view it as cold, hard data, you’ll be able to use this information to improve your trading.
Another reason it’s hard to accept criticism, you my have an irrational need to be perfect. We often assume that unless we are always right, we will not be successful. We learn this assumption from school. In school, we were usually allowed only one chance to turn in a term paper or take a test. In most school settings, you can’t retake a test or rewrite a term paper. Many people carry over this mindset into trading. In trading this doesn’t need to apply. If you make small practice trades, for example, you can make a trade, learn from your mistakes, and make a new trade. Over time, you’ll hone your skills. Since risk is managed, you can make mistakes and learn from them. There’s nothing to fear.
There’s no reason to avoid accepting criticism. Indeed, if you want to be successful at trading, or anything for that matter, you should seek it out, either by making trades and seeing what happens or consulting a trading coach. The more information you get about yourself, the more likely you’ll be able to hone your skills. So seek out criticism. Don’t be afraid to accept your limitations. If you can stand there and take all the criticism you can find, you’ll hone your skills to the point that you will trade the markets skillfully and profitably.
The Graham Approach: How A 60-Year Old Strategy Still Scores Big
October 14, 2011 
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Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Benjamin Graham-inspired strategy, which has averaged annual returns of 14.4% since its July 2003 inception vs. 2.3% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Graham-based investment strategy.
Guru Spotlight: Benjamin Graham
Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world’s richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as “The Father of Value Investing”, Graham inspired a number of famous “sons” — Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.
So, just who was Graham? Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), Graham built his reputation — and fortune — by using an extremely conservative, low-risk approach to investing. To him, preserving one’s original capital was every bit as important as netting big gains, and two factors from his early years may show why. The first was Graham’s own family’s fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived. Graham’s clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe, and Graham worked without compensation for five years until his clients’ fortunes were fully restored.
Having lived through both his own family’s financial troubles and the market crash, it’s no surprise that the strategy Graham laid out in his classic book The Intelligent Investor was a conservative, loss-averse approach. To Graham, an investment wasn’t something that could be turned into quick, easy profits; anything that offers such “easy” rewards also comes with substantial risk, and Graham abhorred risk. True “investment”, he wrote, deals with the future “more as a hazard to be guarded against than as a source of profit through prophecy.”
In terms of specifics, Graham’s “Defensive Investor” approach limited risk in a number of ways, and my Graham-based model lays out several of those methods. For example, one key criterion is that a firm’s current ratio — that is, the ratio of its current assets to its current liabilities — is at least two, showing that the firm is in good financial shape. The approach also targets financially sound firms by requiring that long-term debt not exceed net current assets. Two other criteria the Graham method uses to find low-risk plays: the price/earnings ratio and the price/book ratio. Graham wanted P/E ratios to be no greater than 15 (and, as another signal of his conservative style, he looked not only at trailing 12-month earnings but also at three-year average earnings, to ensure that one-year anomalies didn’t skew the P/E ratio). For the price/book ratio, he used a more unusual standard: He believed that the P/E ratio multiplied by the P/B ratio should be no greater than 22.
My Graham-inspired strategy tends to find bargains across a variety of areas of the market. Here are the current holdings of the 10-stock Graham portfolio:
Forest Laboratories, Inc. (FRX)
LHC Group, Inc. (LHCG)
L.B. Foster Company (FSTR)
UniFirst Corporation (UNF)
National Oilwell-Varco (NOV)
Curtiss-Wright Corp. (CW)
Regal-Beloit Corporation (RBC)
NTT DoCoMo, Inc. (DCM)
Reliance Steel & Aluminum (RS)
United Stationers Inc. (USTR)
Two types of stocks that you won’t find in the Graham portfolio are technology and financial firms. Graham excluded tech stocks from his holdings because they were too risky, and, while they’re not as risky today, I do the same. Financial stocks, meanwhile, aren’t explicitly excluded from my Graham model. But because of the low-debt requirements in this strategy, it’s nearly impossible for a financial firm to garner approval.
Since I started tracking my Guru Strategies more than eight years ago, the performance of my Graham-based model has been rather remarkable. Even though the strategy Graham outlined is now more than 60 years old, it just keeps on working. Through Oct. 12, the 10-stock Graham-based portfolio was up 203.7% since its July 2003 inception, making it my second-best performer. That’s a 14.4% annualized return in a period in which the S&P 500 has gained just 2.3% per year. The model’s strict balance sheet criteria helped it avoid big losers in 2008, as the portfolio lost less than half of what the broader market lost, and it rebounded big in 2009 and 2010, gaining 31.4% in ’09 and 22.6% in ’10. This year it’s had some big swings amid the volatile market, but through Oct. 12 it was minimizing losses, down 2.5% for the year vs. -4.0% for the S&P.
Those figures are a great demonstration of how successful stock investing doesn’t need to be incredibly complex or cutting-edge. You don’t need fancy theories or gimmicks; you just need to focus on good companies whose stocks are selling at good values. Do that, and you should produce some strong results of your own.
Taken from the October 14, 2011 issue of The Validea Hot List
Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world’s richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as “The Father of Value Investing”, Graham inspired a number of famous “sons” — Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.
So, just who was Graham? Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), Graham built his reputation — and fortune — by using an extremely conservative, low-risk approach to investing. To him, preserving one’s original capital was every bit as important as netting big gains, and two factors from his early years may show why. The first was Graham’s own family’s fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived. Graham’s clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe, and Graham worked without compensation for five years until his clients’ fortunes were fully restored.
Having lived through both his own family’s financial troubles and the market crash, it’s no surprise that the strategy Graham laid out in his classic book The Intelligent Investor was a conservative, loss-averse approach. To Graham, an investment wasn’t something that could be turned into quick, easy profits; anything that offers such “easy” rewards also comes with substantial risk, and Graham abhorred risk. True “investment”, he wrote, deals with the future “more as a hazard to be guarded against than as a source of profit through prophecy.”
In terms of specifics, Graham’s “Defensive Investor” approach limited risk in a number of ways, and my Graham-based model lays out several of those methods. For example, one key criterion is that a firm’s current ratio — that is, the ratio of its current assets to its current liabilities — is at least two, showing that the firm is in good financial shape. The approach also targets financially sound firms by requiring that long-term debt not exceed net current assets. Two other criteria the Graham method uses to find low-risk plays: the price/earnings ratio and the price/book ratio. Graham wanted P/E ratios to be no greater than 15 (and, as another signal of his conservative style, he looked not only at trailing 12-month earnings but also at three-year average earnings, to ensure that one-year anomalies didn’t skew the P/E ratio). For the price/book ratio, he used a more unusual standard: He believed that the P/E ratio multiplied by the P/B ratio should be no greater than 22.
My Graham-inspired strategy tends to find bargains across a variety of areas of the market. Here are the current holdings of the 10-stock Graham portfolio:
Forest Laboratories, Inc. (FRX)
LHC Group, Inc. (LHCG)
L.B. Foster Company (FSTR)
UniFirst Corporation (UNF)
National Oilwell-Varco (NOV)
Curtiss-Wright Corp. (CW)
Regal-Beloit Corporation (RBC)
NTT DoCoMo, Inc. (DCM)
Reliance Steel & Aluminum (RS)
United Stationers Inc. (USTR)
Two types of stocks that you won’t find in the Graham portfolio are technology and financial firms. Graham excluded tech stocks from his holdings because they were too risky, and, while they’re not as risky today, I do the same. Financial stocks, meanwhile, aren’t explicitly excluded from my Graham model. But because of the low-debt requirements in this strategy, it’s nearly impossible for a financial firm to garner approval.
Since I started tracking my Guru Strategies more than eight years ago, the performance of my Graham-based model has been rather remarkable. Even though the strategy Graham outlined is now more than 60 years old, it just keeps on working. Through Oct. 12, the 10-stock Graham-based portfolio was up 203.7% since its July 2003 inception, making it my second-best performer. That’s a 14.4% annualized return in a period in which the S&P 500 has gained just 2.3% per year. The model’s strict balance sheet criteria helped it avoid big losers in 2008, as the portfolio lost less than half of what the broader market lost, and it rebounded big in 2009 and 2010, gaining 31.4% in ’09 and 22.6% in ’10. This year it’s had some big swings amid the volatile market, but through Oct. 12 it was minimizing losses, down 2.5% for the year vs. -4.0% for the S&P.
Those figures are a great demonstration of how successful stock investing doesn’t need to be incredibly complex or cutting-edge. You don’t need fancy theories or gimmicks; you just need to focus on good companies whose stocks are selling at good values. Do that, and you should produce some strong results of your own.
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