Why Psychology Matters in the Stock Market?
In 2002 Daniel Kahneman a psychologist was awarded the Nobel Prize in economics "for having integrated insights from the psychological research into economic science, especially concerning human judgment and decision-making under certainty." That signaled the arrival of behavioral finance as a legitimate force in how to think about capital markets. Despite computer programs and black boxes, it is still people who make markets.
Because emotions are stronger than reason, fear and greed move stock prices above and below a company's intrinsic value. When people are greedy or scared, Buffett says, they often will sell stocks at foolish prices. In the short run, investor sentiment---human emotion--has a more pronounced impact on the stock prices than a company's fundamentals.
Long before behavioral finance had a name, it was understood and accepted by a few renegades like Warren Buffett and Charlie Munger. Charlie points out that when he and buffet left graduate school, they "entered the business world to find huge, predictable patterns of extreme irrationality." He is not talking about predicting the timing, but rather the idea that when irrationality does occur, it leads to predicting patterns of subsequent behavior.
Buffett and Munger aside, it is only quite recently that the majority of investment professionals have paid serious attention to the intersection of finance and psychology. When it comes to investing, emotions are very real, in the sense that they affect people's behavior and thus ultimately affect market prices. You have already sensed, I am sure, two reasons why understanding the human dynamic is so valuable in your own investing (1) you will have guidelines to help you avoid the most common mistakes. (2) You will be able to recognize other people's mistakes in time to profit from them.
All of us are vulnerable to individual errors of judgment, which can affect our personal success. When a thousand or a million people make errors of judgment, the collective impact is to push the market in a destructive direction. Then, so strong is the temptation to follow the crowd, accumulated bad judgment only compounds itself. In a turbulent idea of irrational behavior, the few who act rationally may well be the only survivors.
In fact, the only antidote to emotion-driven misjugment is rationality, especially when applied over the long haul with patient perseverance.
The intersection of Psychology and Economics:
The study of what makes us all tick is endlessly fascinating. It is particularly intriguing to me that it plays such a strong role in investing, a world that is generally presumed to be dominated be a cold numbers and soulless data. When it comes to investment decisions, our behavior is sometimes erratic, often contradictory, and occasionally goofy.
What is particularly alarming, and what all investors need to grasp, is that they are often unaware of their bad decisions. To fully understand the markets and investing, we now know we have to understand our own irrationalities. The study of the psychology of misjudgment is every bit as valuable to an investor as the analysis of a balance sheet and an income statement.
In recent years we have seen what amounts to a revolution, a new way of looking at issues of finance through the framework of human behavior. This blending of economics and psychology is known as behavioral finance, and it has slowly moved down from the universities ivory towers to become part of the informed conversation among investment professionals...who, if they look over their shoulders, will find the shadow of a smiling Ben Graham.
You must be logged in to post a comment.