An article to read what is behavioral finance and how to use behavioral finance for investment practice

Every time you buy a certain stock, it begins to fall, sold but began to rise again?

Every day is concerned about the stock rise and fall, but buy and sell to finally earn a lonely?

I wanted to rush into the bottom of the bear market, the results of the loss of more miserable?

Obviously put the money in a few baskets, the result is still not escape the risk?

Learned a whole lot of investment knowledge, in the end does not seem to be of much use ......

Do you also have these problems in your investment? Do you want to solve these problems? It's time to learn about an emerging discipline - behavioral finance. Because to be profitable in investing, you not only need to have knowledge of finance, but also need to understand human nature and know how human behavior will affect your investment.

Lu Rong's Behavioral Finance Lecture Notes is a primer on behavioral finance, which explains what behavioral finance is, how human psychology affects investment behavior, and how to use behavioral finance to guide investment practices with a large number of cases. The author Lu Rong has systematically studied behavioral finance in famous universities in the United States and has rich practical experience. She is currently a chair professor of finance at the Shanghai University of Finance and Economics, and her behavioral finance class has attracted much attention in the investment circle. Reading this book will not only provide a comprehensive understanding of the theoretical knowledge of behavioral finance, but also help and inspire investment practice.

There is a joke circulating at the University of Chicago. Someone exclaimed, "There's $100 on the ground!" The traditional financier says, "That's impossible; it would have been picked up long ago if there had been any." The behavioral financier says, "How is it impossible?" He ran to see that there was indeed $100 on the ground, and happily picked it up.

This is the difference between behavioral finance and traditional finance. Traditional finance studies is the market "should be" what, from the perspective of equilibrium, there should not be $ 100 on the ground, which is the long-term trend and law, while behavioral finance studies is the market "actually is" what. When looking at things in any field, the "should be" perspective helps us to grasp the long-term benchmarks, and the "actually is" perspective helps us to understand what is happening in the present.

Finance studies the laws of financial society, and psychology specializes in human behavior. Behavioral finance is a cross-discipline between psychology and finance, which analyzes the impact of human psychology, emotions and behavior on financial decisions, prices of financial products and financial market trends.

Behavioral finance tries to explain what investors invest in, why they invest, and how they invest from the perspective of human psychology and behavior. Therefore, behavioral finance is good at investment practice, closer to the real situation of the financial market and the actual behavior of human beings. More and more top fund companies began to use behavioral finance trading strategy, Wall Street investors will always keep a close eye on the research of behavioral finance, Harvard University, University of Chicago, Peking University, Wudaokou Institute of Finance and other colleges and universities, as long as the first to open the relevant courses or lectures, basically a hard to find. Even the Nobel Prize in Economics has favored it, and the Nobel Prize in Economics in 2002, 2013 and 2017 were awarded to behavioral financiers, which shows that behavioral finance has a great influence in the practical and academic world.

To y and systematically understand behavioral finance, you first need to understand the three major theoretical foundations of behavioral finance: the limited rationality hypothesis, limited arbitrage, and prospect theory.

1 . Finite Rationality Hypothesis

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Traditional finance assumes that people are "rational beings", and its basic characteristic is that every person engaged in economic activities takes economic behavior and decision-making is to use the smallest cost to obtain the greatest economic benefits.

However, when we look at the way people make decisions and behave in the real world, we find that there are many flaws in the assumption of the "rational man". Based on this, Herbert Simon, the Nobel Prize-winning economist, put forward the hypothesis of limited rationality, in which he argued that people in real life are "limited rationality" between complete rationality and irrationality. Because people's knowledge, time and energy are limited, their value orientation and multiple goals are not always the same, and are often in conflict with each other. In reality, people are limited in their ability to make decisions rationally, and the choice of decision-making is not in the absolute value of utility, but in the satisfaction, all decisions are comparative.

Saying a very common scene in reality, the boss gave you a bonus of 10,000 yuan, you are satisfied or not, not in 10,000 yuan for you is more or less, but depends on how much your other colleagues took the bonus.

2 . Limited arbitrage

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Traditional finance believes that arbitrage can eliminate all price bias, even if there is only one person in the world is rational, are able to complete arbitrage, and then can correct the price bias. Under the theoretical framework of traditional finance, as long as there is the existence of arbitrage behavior, in the long run, prices will converge to a reasonable level without the problem of price bias.

In fact, three conditions are required to realize successful arbitrage: zero cost, no risk, and positive returns. If there was something that cost no money, had no risk, and made money, how much money would people be willing to use to do it? Rational people should use the world's wealth to do this until this arbitrage opportunity is eliminated.

But in the real market, arbitrage has a cost, and no matter which market you buy or sell in, you need to pay margin; at the same time, arbitrage is risky because the spread doesn't necessarily converge quickly, and in the process of arbitraging, the spread may also get wider and wider; furthermore, the return on arbitrage is not guaranteed because the arbitrageurs don't necessarily hold on to the moment of victory. Therefore, there is a limit to arbitrage in the real market, which is what behavioral finance calls limited arbitrage.

3 . Prospect Theory

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Prospect theory recognizes that each individual has a different attitude towards risk because they are based on a different reference point. Through a series of experimental observations, Prospect Theory has found that people's decision-making choices depend on the gap between expectations and assumptions, rather than the outcome itself. People make decisions with a reference point in mind, and then measure whether each outcome is above or below that reference point. For gain-based outcomes above the reference point, people tend to be risk averse, favoring small, certain gains, while for loss-based outcomes below the reference point, people are risk-averse, hoping for good luck to avoid losses.

This theory explains well why many people, when investing in stocks, will always sell the stocks that are making profits and hold the stocks that are losing money for a long time. This is because, when faced with gains, people tend to be cautious and unwilling to take risks, while when faced with losses, they become risk-takers.

On the other hand, people's reaction to probability is also irrational; people usually overreact to small probabilities and underestimate large ones. For example, although the probability of winning the lottery is small, there are always people who buy lottery tickets and dream of getting rich; although the probability of getting into a car accident is small, most people are still willing to buy insurance.

The so-called cognitive bias refers to a person's inability to correctly recognize what he or she wants to know. It is because of these limitations that people are not completely rational in making decisions. The following describes the cognitive biases and decision-making biases that are common to investors, as found in behavioral finance research.

1. Representativeness bias

Representativeness bias means that when people analyze and understand an unfamiliar thing, they will habitually classify the thing according to the past tradition or similar situation, and tend to make decision-making judgments based on the representative characteristics of the thing. In financial markets, representativeness bias is very common. For example, many investors see a company doubling its profits for 3 years in a row and then immediately make a judgment about its stock - buy it! This is representativeness bias at work. "Doubling profits for 3 consecutive years" is a representative characteristic of a good company, but it doesn't mean that the company is a good company because, among other things, there is a lot of important information that has been overlooked. For example, good performance may be intentionally adjusted out; the company's profit opportunity disappears, the performance can not be sustained, and so on.

2. First Cause Effect and Proximate Cause Effect

The first cause effect is often referred to as the first impression, which refers to the tendency of people to give the greatest weight to the information that arrives at them for the first time when they make decisions. In contrast, the proximate cause effect refers to the fact that the information that arrives last is given the most weight.

Let's take a look at the following two sentences:

"I'll recommend a stock for you, A stock with good returns, but, it's risky!"

"I'll recommend another stock for you, B stock has risk, but, good returns."

Which stock do you feel is better? Most people feel B is better. But really the two statements mean the same thing, just the information is presented in a different order.

With this example you should feel the influence of proximate cause effect on people's decision-making behavior. As for which effect people will be affected by in reality, it mainly depends on the speed and intensity of the information arriving.

3. Overconfidence

Psychologists believe that normal people are generally overconfident. Overconfidence in people is related to the accumulation of information. When a person does not have any information and knowledge, he is not confident, with more and more information collected, his ability to enhance accordingly, self-confidence will be synchronized. However, there is no upper limit to the accumulation of information, but there is an upper limit to the enhancement of ability. Eventually, one's level of confidence will exceed one's actual level, which is why one can be overconfident.

Overconfidence in the investment behavior caused by the main: frequent trading and risk-taking. Overconfident investors often should not buy when they keep buying; should not sell when they keep selling. Many investors do a lot of trading, but found that did not make any money, the more you do, the more you lose, these are caused by overconfidence.

4. Reference point dependence

People like to find a reference point when making decisions, and will need to decide things with this reference point for comparison, and then according to the information obtained to gradually amend their own decisions. The reference point acts as an "anchor" and influences our decisions.

For example, A is going to buy a quilt, which is normally sold at the mall for RMB 1,000 per bed for a deluxe double quilt in extra-large sizes, RMB 600 per bed for a fine double quilt, and RMB 400 per bed for a regular double quilt. During the event, all sizes are sold for only $300.

Influenced by the reference point, A ends up buying the oversized deluxe double comforter because it's the best value, but in reality the oversized comforter doesn't match the size of his bed. Recall if you've made many of the same decisions as A. Many people don't buy things based on the absolute price or whether they need it or not, but on whether it's cheap.

5. Mental Accounts

In our minds, separate accounts are created for different uses of money, and a mental budget is used to match the costs and benefits of each mental account. In other words, the decision maker has multiple mental accounts, each of which is being kept in a separate book.

Think about how you would make decisions in the following two situations.

In the first scenario, you buy a concert ticket for $1,500, and on your way there, you realize that the ticket is missing. Would you buy another ticket?

In the second scenario, you plan to go to the venue to buy a concert ticket for $1,500, but on the way there, you lose the $1,500. Would you go ahead and buy the ticket for the concert?

From a traditional financial perspective, the two scenarios are really the same, with $1,500 missing from the person's real account. But studies have shown that most people will choose to go home after losing their ticket, and will choose to buy a ticket after losing their money. In other words, if the first scenario occurred, most people would choose not to buy another ticket; whereas in the second scenario, most people would choose to buy a ticket. This is the effect of mental accounts on human behavior.

Psychological accounts can lead to a lack of long-term vision, an inability to look at the problem from a global perspective, and overly conservative investments due to aversion to loss. Ultimately, the total portfolio is not optimal for the investor, and the investor's risk diversification comes from the diversification of investment objectives rather than the diversification of assets required by Markowitz's portfolio theory.

Anomalies are phenomena in which the actual returns on assets in financial markets deviate from the capital asset pricing model and the efficient market hypothesis. That is, anomalies occur in financial markets that defy the traditional risk-return correspondence theory of finance. The following describes several anomalies in the financial market found by behavioral finance research.

1. Size premium: the small-cap anomaly

The higher stock returns of small firms is the first financial market anomaly found in behavioral finance research. Empirical studies have found that the stock returns of companies of different sizes are different, and among them, the returns of small companies are higher, which is the size premium, and this anomaly arises because investors misestimate the value of small-capitalization stocks and then dislike investing in these stocks. In the United States, due to the lack of liquidity of small-cap stocks, so only some closed-end funds are willing to hold small-cap stocks, large institutions are less willing to hold small-cap stocks, which creates the small-cap anomaly.

Traditional finance believes that the best way to buy stocks is to have a random allocation, that is, to buy a little bit of all the stocks in the market, so that the risk is the most diversified and the return is optimal. And the small-cap anomaly tells us that buying only small-company stocks is more rewarding than buying randomly between large- and small-company stocks.

It's important to note that the Chinese market is not quite the same as the U.S. market. The Chinese investment market is dominated by retail investors, so Chinese investors have different preferences for large and small stocks than U.S. investors. So it is possible that the size premium strategy will not work well in China.

2. The Equity Premium Puzzle

The Equity Premium Puzzle first originated in the research of Roger Ibbotson, a professor at the University of Chicago. According to his research on the return on investing $1 in different assets from 1925 to 2016, it was found that the return on equity assets was much higher than that on other assets, a phenomenon that could not be explained by traditional finance theories, and was therefore known as the Equity Premium Puzzle.

This shows that equity assets are a particularly suitable asset for allocation. Theoretically, regardless of the degree of risk aversion, a family or individual investor should allocate some equity assets, because doing so is consistent with the logic of investment. In practice, however, less than 50% of households in the United States own stocks, and household stock ownership rates in other countries are even lower. This is because of the high one-time costs of investing in stocks, and these costs include the cost of wealth, the cost of time, and the cost of learning.

3. Overreaction and Underreaction

Overreaction is when investors place too much weight on changes in asset prices, and extrapolation of near-term trends leads to inconsistency with long-term averages. In contrast, underreaction is when asset prices do not respond adequately and in a timely manner to fundamental news that affects the value of a company.

Overreaction can cause asset prices to fall excessively in response to bad news and rise excessively in response to good news. And underreaction occurs when the market does not react in a timely manner to stock prices when good and bad news emerges.

Overreaction and underreaction are primarily the result of investor overconfidence and self-attribution bias. Overconfident investors overreact to private information and underreact to public information. Self-attributing investors attribute the success of their investments to their high ability and attribute the failure of their investments when they are affected by external factors.

The core of a profitable investment strategy under the theory of behavioral finance is: taking advantage of people's mistakes. The basic trading strategy is to look for anomalies in the financial markets as described above, and to make investment moves in the opposite direction of the errant investor. Here are a few behavioral finance theory of investment practice guide and strategy.

1. Suggestions for investment guidance based on Miller's hypothesis

Miller's hypothesis suggests that when the market finally reaches equilibrium, stock prices must be overvalued, reflecting the sentiment of the optimists, with the optimists acquiring all the stocks, rather than stocks accurately reflecting the average investor's expectations, as expected by rational theory.

Thus, Miller's hypothesis is instructive to investment practice in that it allows us to recognize that valuation bubbles are the norm, that we cannot analyze the market based on fundamentals alone, and that understanding investor psychology and behavior is critical to investment practice. In addition, the more trading volume is released, i.e., stocks are trading in larger volumes, the more alert we need to be to the presence of bubbles. Also, investors need to be aware of markets and securities that are particularly difficult to sell short or that lack liquidity.

Asset bubbles are very detrimental to the entire financial market, and investors need to be fully aware of the risks of long-term holdings and not blindly copy the concept of value investing. So how do investors judge the market bubble, when to buy, when to sell? To solve this problem just remember: good out of the short, short out of the good.

2. Reverse investment strategy for overreaction

Reverse investment strategy is to buy stocks that have performed poorly in the past and sell stocks that have performed well in the past to carry out arbitrage investment method. Behavioral finance theory suggests that because investors tend to focus too much on the recent performance of listed companies in their actual investment decisions, this leads to a sustained overreaction to the company's recent performance, creating an overvaluation of the stock price of poorly performing companies, and ultimately providing an arbitrage opportunity for the inverse investment strategy.

3. The opposite strategy for herd behavior

The so-called herd behavior is the herd behavior of investors, see what other people buy what to follow, due to the existence of herd behavior, the overreaction of the securities price is inevitable, so that there is a "rise over the top" or "fall over the top". "Down too much". Investors can use the stock market price reversal can be expected to take the opposite investment strategy to arbitrage trading. Examining the historical trend of China's stock market, we will find that in the important top or bottom area, the news is always accompanied by the introduction of some important stock market policy. Different investors react differently to policies. In response to the behavioral response pattern of individual investors, the investment fund can develop a corresponding behavioral investment strategy - the opposite investment strategy, to carry out active swing operations.

4. How to Find Effective Trading Strategies

As important as it is to understand the trading strategies that are currently available, it is even more important to learn to find effective trading strategies on your own if you want to profit from your investments.

For the investment community, these financial market anomalies are the basis for the formation of behavioral trading strategies that are secretive in nature, and institutions that use behavioral financial trading strategies do not disclose their profit factors. So where should we look for robust anomalies? The authors offer two ways: one is to discover earnings anomalies by reading good academic journals; the other is to attend the annual Academic Finance Conference, where behavioral finance trading strategies are featured in these up-to-date academic research conferences.

Additionally the authors present 97 anomaly factors in the book, all of which have been research-tested by behavioral finance academics and can inform your investment decisions.

Behavioral finance investment strategies are all based on the visions found to trade accordingly, and it is important to note that no one vision works consistently. As more and more people become aware of it, its utility will decay. At the same time, investors need to realize that no trading strategy works consistently, they all only work for a period of time. So investors need to keep looking for new ways to profit.

Behavioral finance tells us how financial markets actually work, why profitable trading strategies exist, how to avoid investment mistakes, and how to make a profit. It can be said that a qualified investor should understand behavioral finance. Behavioral finance not only provides another complete set of financial thinking, but also in a more effective way to influence people's judgment and decision-making on the financial market.

Lu Rong's Lecture Notes on Behavioral Finance is a book that is both intellectual, interesting and readable, and includes two major parts: the principles and applications of behavioral finance. The theories of behavioral finance taught in the book are not only applicable to financial market investment, but even helpful to the way you conduct yourself, view society and live your life. No matter who you are and how much you know about the financial markets, I hope you will understand yourself, the market and life better after reading this book.

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