Behavioral Investing: How to Use the Principles of Behavioral Finance To Make Money

Posted by Alex Frey (@alexhfrey )

Reading fun psychological experiments and understanding the market from a theoretical perspective is all well and good, but at some point the goal of investing is quite simple: to make money. This article will look at different ways that you can employ the principles of behavioral investing to achieve that righteous goal. 

Two Ways to Invest Behaviorally

The presence of so-many apparent market anomalies (or deviations from rationality) opens the door to the possibility of earning returns that are higher than those of the market by systematically exploiting other people's irrationality. This idea has spawned an emerging field of "behavioral investing" which looks to do exactly this.

Ideas from behavioral investing can be split into two categories. The first category is concerned with how we can avoid making predictable psychologically-driven mistakes in our own decisions (not as easy as it looks!). We will call this playing "behavioral defense." The second is concerned with how we can then exploit other people's biases to earn excess profits. We will call this playing "behavioral offense."

How to Play "Behavioral Defense" With Your Investments

Techniques for behavioral defense start with the idea that many investing mistakes result from making decisions "in the heat of the moment" when our emotions are likely to take over and we are more likely to rely on ad-hoc rules of thumb. The quick decision making rules (known as heuristics) that our brain evolved to cope with life on the African serengetti do not always apply so well in the modern financial markets. The anecdote to making decisions based on "hunches" is to have a thought-out and written-down process that answers questions like:

  • What is your overall "theory of the markets"? Are you trying to beat the market or "meet the market?
  • What is your overall asset allocation strategy? Do you believe in tactical asset allocation, strategic asset allocation, or some combination of both?
  • What new information would you need to see to change your mind about the way you should invest?
  • How often will you re-assess your portfolio?
  • What kind of rebalancing strategy will you take?
  • If you intend to invest actively, what what kind of signal will you look for to "buy" an investment? What will your sell condition be?

Also key is to avoid becoming "attached" to investments or suffering from loss aversion. If you intend to  invest actively, it can be useful to periodically go through every position and ask yourself "If I did not already own this investment, would I purchase it today?" If the answer is no, then you need to ask yourself if the only reason you are still keeping it is an irrational desire to avoid "admitting defeat?" Or perhaps you have become emotionally attached?   

An option for an even stronger behavioral defense is turning your investment implementation over to a "system" altogether. By thinking about the "rules" that you want to follow in advance of putting any real money into play, you can remove the impact of emotional decisions, and go so far as to program a computer to follow your rules so you can tune out of the investment process just about entirely. This is an approach that is used by many of the very best hedge-funds in the world, such as Renaissance Technologies and Bridgewater, who have figured out how to take emotions and faulty heuristics totally out of the process. 

"Offensive" Behavioral Investing

Playing good "behavioral offense" is a step up on the aggression scale from playing behavioral defense. But given that there are some somewhat predictable market anomalies like momentum we think are likely to persist into the future, best practices are to divert a greater percentage of your portfolio towards areas that are likely to out-perform, and a lesser percentage of your portfolio towards area that are likely to underperform, while keeping in mind that nothing is a sure thing in the financial markets. 

For instance, we know that behavioral biases that may be likely to continue can produce predictable market anomalies. We might rationally expect some of these anomalies that are grounded in the psychology of markets to continue. For instance,  high growth "glamore" stocks will underperform value stocks over time, momentum will continue, etc. So using this we can design a quantitative investing algorithm that exploits known biases by always positioning us to take the other side of these trades, on the side that is likely to out-perform in the future, but might be psychologically painful to hold on to in the short-term. 

Behavioral Investing and Ivyvest

The Ivyvest ETF Portfolios have elements of both behavioral defense and behavioral offense. Defensively, we take emotions and faulty "hunches" out of the process by designing our investment strategy in advice of executing it, so we will never have to make "spur of the moment" kind of calls, but instead can rest on our dispassionate analysis of years of data and basic economic logic. 

Offensively, our portfolios are built to outperform the markets over time by "harvesting" well-known behavioral biases like momentum and valuation. 

In the next article, we will take a closer look at momentum investing, a field that attempts to exploit one of the largest and most established market anomalies of them all. 

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By Alex Frey