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The Rise of Behavioral Finance


Next wave in investment thinking.

Information, like breathing, is taken for granted by most individuals. Yet, information -- specifically new information that investors receive -- can serve 2 purposes if an investor is tuned to its dual investment uses. And, as you see, this will take a receptive investor into a world of understanding about human nature that can yield significant investment results.

The first and most obvious use of new information is to enhance one's knowledge and understanding of a given subject. The important question here is: Does the new information support or refute my current point of view? This sounds easier than it is in real life - behavioral scientists will tell you all individuals have biases and prejudices that influence how we receive new information.

For most, new information is used to validate a given point of view. Yet new information should also be used to challenge, potentially refute, and, if necessary, alter a given point of view. The problem is that personal biases and prejudices get in the way of rational decision-making -- which is what incorporating new information into all decision-making, including investment-related decisions -- should accomplish.

I won't go into all the personal biases and prejudices we humans bring to the new-information table, but a good starting point is this list of cognitive biases.

I'd also encourage you to look into the work of behavioral experts like Daniel Kahnemann (Nobel laureate) and Richard Thaler (author of Nudge), among others.

There's a second, equally significant, use of new information, which far too many investors give little to no thought to; for some, it doesn't even register on the radar screen. I'm referring to the way others will interpret (and act) upon new information. It's in this area that investors can exploit the tendencies and consensus views that build from the new information received. Think of this second point as a mass version of the first point: information received writ large.

The key investment decision-making questions that arise from this second point is: Should I follow the crowd or run against it? And this gets to the heart of what kind of investor you are - a trend follower (momentum player) or a contrarian?

Investment Strategy Implications

Behavioral science will be the next step in the evolution of economic and investment thinking. With the destruction of laissez-faire, American-style cowboy capitalism, academics, policy makers, and practitioners will look toward the behavioral sciences to provide insight into the new economic philosophy that will replace what's been discredited.

Investors can start by learning about the finance part of behavioral science (behavioral finance) and adapting it to their established investment methodologies - a form of incorporating new information. Investors can also look at the news, data, and opinions that are pumped out daily -- and bombard the investment decision-making senses -- to see how it can be used for investment success.

In this regard, knowing how the new information enhances or refutes one's established opinion, and how others are likely to interpret the new information, is one very helpful way toward a better understanding of that beast known as the investor.

As dispassionate as the traditional economic and financial textbooks might lead you to believe, investors are anything but rational beings - particularly over the near term. One need only look at the events of the past 2 decades (not to mention the past 2 years) to get a clear picture of how irrational things can get.

Understanding how new information is absorbed is a solid first step in understanding how people make decisions.
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