- You are ultimately the one buying or selling a stock
- The price action in the stock market is the result of the collective buying and selling decision from investors and individuals
- Avoid herd behavior and overtrading
- Sell losers, not winners
- Secure a stop loss in mini bubbles and short mini bubbles
You are ultimately the one buying or selling a stock
“Behavioral finance is not a branch of standard finance: it is its replacement with a better model of humanity”
Regardless of what investing framework, you follow; you are ultimately the one buying or selling a stock. Behavioral finance incorporates the human element, the final missing link into finance. People do not always behave rationally as economic models assumed, we are innately susceptible to overconfidence, bias judgments, herding, and loss aversion. These elements create inefficiencies in the market which opens up opportunities for experienced traders and an avenue of significant loss for new traders.
New traders are often convinced that they can control their investment results. They end up investing their whole portfolio into a single stock without much research. A few new traders may end up lucky, but most will face an unrecoverable loss. The stock market is a zero-sum game, so there can only be a few winners. This is the game. These are the rules.
The price action in the stock market is the result of the collective buying and selling decision from investors and individuals
Millions of investors and individuals by their collective buying and selling decisions produce the price action in the stock market. As we have seen in the past, the market as a whole does not always correctly price assets. We have seen the internet bubble and the real estate bubble. The existence of “group think”, a phenomenon in the study of crowd behavior, creates these bubbles. Groups of overoptimistic individuals will sometimes reinforce one another into believing in unrealistic prices, or the unlimited potential of some technology. People have lost millions participating in these efforts and only a few became wealthy and stay wealthy.
In the art of trading and investing, like any game, we want to win. What can we do to prevent these innate behaviors? And what can we do to take advantage of this?
Avoid herd behavior
Ask yourself why you are investing in a stock? When researchers surveyed people, who invested in the internet bubble, most said a personal contact recommended the stocks. When any investment becomes the topic of widespread conversation, it is especially hazardous. In investing and stock trading, you must think for yourself and question any grandiose claims.
New traders are often overconfident about their abilities. They trade frequently, moving from one stock to another. Most of the time, investors accomplish nothing but incurring transaction costs and more taxes. Warren Buffet famously said:
“Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever”
Sell losers, not winners
Investors are more likely to hold on to losses than to hold on to gains. Generally, investors will sell their winners to enable them to enjoy the success of being right. However, sometimes, it is sensible to hold on to losers when you have real reasons to believe that the company is still successful.
Secure a stop loss in mini bubbles
If you are lucky enough to buy a stock before it explodes, you need to make sure you lock a stop-loss price and not hold onto the stock. Most of the time explosion in price is driven by crowd behaviors.
*Stop losses can go unfilled and stock prices can open many points below the previous day close. You need to be mindful of these realities during a mini bubble
Advanced ideas: Short mini bubbles
Whenever the price explosion is driven by nothing but popular opinion, an opportunity to short a stock may present. Shorting is dangerous, but when the signs of a bubble are obvious, why not? There is a ton of complexity involved including dealing with interest rates for borrowing and opening a margin account so be careful. Shorting stocks is not for everyone, especially new traders.
Advanced Idea: Short overvalued IPOs
Initial public offering (IPO) has been seen as a path to riches. IPO can trade three to eleven times their earnings. However, IPO can also be seen as a mini-bubble. Poor performance starts 6 months after the issue is sold. Six months is generally the “lockout” period in which insiders are prohibited from selling stocks to the public.