Behavioral finance

I wanted to touch upon a subject I spend a lot of time reading. This is called behavioral finance. Now the followers of Efficient Market Hypothesis do not believe in behavioral finance, per them market is a self correcting mechanism and any price anomaly in market due to behavioral aspects of market players is corrected immediately. I obviously belong to the Behavioral Finance club and firmly believe that markets are driven by two fundamental human behavior- fear and greed.

These two human trait lead to herd like behavior between market players, which has not changed over a million years of human evolution. The rational behavior is soon overtaken by irrational behavior of greed and fear. Many financial bubbles in the history are a result of these traits- be it the dutch Tulip bubble of 1624 or the 1929 stock bubble of America or the 2000 dot com bubble of NASDAQ or the very recent 2008 bubble of real estate. No rational behavior can explain the ridiculous price extreme that these bubble era experienced and then the subsequent collapse.

I wouldn't be able to do justice to this topic unless I also delve little deeper and introduce the concepts of heuristics, anchoring, frame dependence as it applies to behavioral finance.Heuristics is pretyty common in investors and I have myself fallen into this triap more than I would liek to admit :-)heuristic implies resorting to some kind of gut feeling for what the prices should be, in other words shortcuts are taken on the asset valuations one comes to a quick conclusion, conclusion that confirms our bias, aptly called confirmation bias. The fear and greed also comes in play, one gets greedy and therefore impatient to join the perceived rally or fearful of a price correction and dump the position prematurely.

Some other words you would hear in the area are - "anchoring", "frame dependence", "Get evenitis". It is important for the investors to understand the implication of these human foibles ...because it is not one rational person who makes the market but the humans predisposed in our evolution towards fear and greed who collectively move the market. if one wants to survive these turbulent markets a through understanding of these human instincts is a must.

if I have raised sufficient interest in you to know more about this subject, may i recommend you two books by people considered authority in this field.

1) Beyond Greed and Fear by Hersh Shefrin and
2) Irrational Exuberance by Robert Shiller.

Enjoy the read and happy safe investing! Remember the words of famous investor and one of my role models- George Soros - "The worse a situation becomes the less it takes to turn it around, the bigger the upside." and then the words of legendary Warren Buffet and the second richest man on earth- "be fearful when others are greedy and be greedy when others are fearful". Hmmm...point noted Mr Buffet!!!