When investors hear about investing and psychology in the same sentence, they might want to pay close attention. Something really good or really bad might be about to happen. So, have you heard the term behavioral finance before? As markets are looking for more ways to understand human behavior and opinion, the field of behavioral finance seems to be gathering steam.
24/7 Wall St. recently had a chance to speak with psychologist and behavioral finance expert Daniel Crosby to ask a few questions about how investors can integrate behavioral finance into their investing strategies.
Investors are told over and over that the odds are against them. They hear that the stock market is like a casino or that investing is not really any better than gambling. And they frequently hear that the machines have taken over, or that the smart money knows more than the average guy. Behavioral finance can be used by regular investors as a means of mitigating at least some of their concerns.
24/7 Wall St. chose to use the Investopedia definition of behavioral finance specific to investing, as follows:
Behavioral finance is a field of finance that proposes psychology-based theories to explain stock market anomalies such as severe rises or falls in stock price. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.
Daniel Crosby recently wrote a book on behavioral finance called The Laws of Wealth and he is the founder of Nocturne Capital. The Laws of Wealth focuses on how the psychology of behavioral finance can help unlock the secret to successful investing.
Crosby’s view is to use timeless principles for managing your behavior and how to use those toward your own investing process. He has ten rules as the hallmarks of good investor behavior. Crosby also shows how behavioral risk can be combatted and how to take advantage of behaviorally-induced opportunities in the stock market. Clear direction is also offered for investors.
Dr. Crosby has been trained as a clinical psychologist and he applies this in his work as an asset manager. One key takeaway here — You need to follow a set of steps to manage your behavior and improve your investing process.
Crosby’s Nocturne Capital is an investment management firm with an approach rooted in the science of behavioral finance. Their strategies use proprietary research into behavioral mispricing and macro sentiment, combining conviction and value. The firm now has its proprietary Nocturne Investor Sentiment Index (NOISI). Their site says:
Our patient, contrarian approach seeks to capitalize on investor misbehavior and arbitrage emotion-driven mispricing. Nocturne’s edge is derived from a stringent process that mitigates fund manager irrationality, a high conviction approach that offers the potential for true outperformance and a proprietary tactical overlay that measures market sentiment.
24/7 Wall St. was given the chance to ask Dr. Crosby some basic questions on how behavioral finance evaluation can help investors succeed when they keep getting told that the odds are against them. We have reformatted our interview in a Q&A format here.
How could understanding behavioral finance have helped investors during the recession?
DC: To be honest, it wouldn’t have helped much in isolation. It is an unfortunate reality that knowledge and behavior have only a weak correlation, which explains why 1 in 5 Americans smoke when roughly 5 in 5 Americans know that it is a horrible decision. I buy a Cinnabon in airports not because I lack awareness of its nutritional content, but because it provides me short-term relief from the stresses of business travel.
Likewise, investors make poor investment decisions in the moment, not because they lack an awareness of the fundamentals of good investing, but because it feels like the thing to do at the time. Unfortunately, with both Cinnabon and fearful selling, the long-term results are pretty grim. Education is an important first step, but even more important is to work with an impartial guide who can keep you from making a handful of catastrophically bad financial decisions over an investment lifetime.