Much of my time is spent analyzing, contemplating, and understanding one topic: Behavioral Finance. Perhaps this is due to my particular circumstances or perhaps it is the wave of the future, but this concept is critical to every decision I make with regard to investment strategy. Quantifying aspects of behavioral finance is the driving force behind many of our asset allocation decisions. And we are not alone; companies have created algorithms and populate databases while trying to measure investor sentiment via Twitter. As a side note, this is a decent concept, but ultimately there are too many formulaic exceptions that need to be written in order to accurately gauge future price movement (i.e. it will not adapt well to future conditions).
The following is an excerpt from What Investors Really Want by Meir Statman:
Our ability to find real patterns is a mark of our intelligence, but our intelligence often backfires, as when we identify illusory patterns as real. Imagine that we are facing machines with two levers marked S and B. The machines dispense nothing if we pull the wrong lever but they dispense $10 if we pull the right one. We’ll get to pull levers many times. A pattern is programmed into the machine but we do not know what it is… How would we go about the task if we want to get the most money out of the machines?
We look for patterns by trial and error… Pigeons rewarded by food find the winning strategy after a few trials and stick to it. But humans rarely stick to that strategy. Instead, we continue to try many strategies, switching between S and B until the game ends…
The world of investments is unnerving because it includes patterns, even if weak, which enable some investors to beat the market. And the promise of patterns sustains the hope of other investors.
I have not finished reading the book and I am not yet recommending it. What I am recommending is a study of your own behaviors and how they impair your ability to win. Ultimately, in this arena, winning comes from not losing. Once you move away from that parameter (i.e. when winning becomes about relative performance), conditions become volatile and are very susceptible to negative absolute return. Negative return, after all, qualifies as a loss, no?