BULLS & BEARS: Expect irrational behavior, and learn to profit from it

April 17, 2006

Investment theories that have dominated thinking in the last half century or so have all stemmed from the efficientmarket hypothesis.

These theories assume investors make rational decisions, all financial information is known by everyone, and all markets are efficient because prices are a combination of all those things.

But in the last decade or so, behavioralfinance studies have postulated that irrational behavior by investors is actually a strong driving force behind markets-and that irrational behavior can be measured and acted on.

Think of the basic economic maxim of supply and demand. It assumes consumers will make intelligent and logical decisions when they purchase an item.

But we all know purchase decisions are complex.

Some consumers believe high price is a signal of quality. Or consumers buy an item because it's the popular thing to own, is a certain brand, props up their self-esteem, or sends a statement.

Take hybrid cars as an example. I have nothing against hybrids, but you need to do some funky math to justify buying one for pure economic reasons.

Buying a Louis Vuitton purse instead of another purse for a third or a 10th of the cost is not rational economics.

Investors are no different from consumers and are probably more influenced by their psyche. Emotions run high when big money is involved.

For instance, investing in a socially conscious mutual fund is not rational when competing funds have stronger records.

Research at Princeton University, Yale University and the University of Chicago has identified several behaviors investors display. As it turns out, they are much more distressed by losses than they are happy by the same amount of gains. Make 10 grand and you're happy, but lose 10 grand and you're really peeved.

People feel sorrow after making an error in judgment, thus they avoid selling stocks that have gone down to avoid the regret of having made a bad investment. Still own Lucent that you bought in 1999? Don't fret; after the pending merger with the French firm Alcatel, you'll feel better.

People typically give too much importance to recent events and extrapolate current trends, which are way out of sync with long-term trends and odds. This is why people become more bullish as markets near peaks and more bearish in the valleys.

As it turns out, the "dark science" of technical analysis and behavioral finance are tightly interwoven. A hundred years of investor reactions have created a record of repetitive and somewhat predictable price moves.

All this vast historical data combined with today's fast number-crunching computers can help separate your emotions from your money.

One of the better sources of this type of information I have found is the Web site www.sentimentrader.com.


Gilreath is co-owner of Indianapolis-based Sheaff Brock Investment Advisors, money management firm. Views expressed are his own. He can be reached at 705-5700 or daveg@sheaffbrock.com.
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