Investment Advice From a Psychologist

"[T]he act of trading is 20% intellectual and 80% psychological," wrote seasoned trader Michael Martin in The Inner Voice of Trading. Most veteran investors, whether they are day traders or long-term investors, would probably agree. Not surprisingly, Daniel Kahneman, widely credited as the father of behavioral economics, has specifically addressed psychology's impact on investment decisions on many occasions. Notably, there are valuable lessons for investors in his book, Thinking, Fast and Slow. Here is some of his best investment advice.

Don't listen to your gut
Recounting a tale of a "chief investment officer of a large financial firm," Kahneman highlights the blinded intuition that often guides even professional investors. The chief investment officer, or CIO, insisted that a particular stock was worthy of an investment in the tens of millions of dollars, simply because he had a gut feeling -- after attending an automobile show -- that the company would succeed.

In other words, the CIO made the investment simply because he liked the cars the company was producing, Kahneman explains. In doing so, he avoided answering the question every investor should ask: Is this stock undervalued?

The CIO suffered from the "affect heuristic, where judgments and decisions are guided directly by feelings of liking and disliking, with little deliberation or reasoning," writes Kahneman.

Though companies with likable products are sometimes great investments, too, investors should still do their homework to get a better picture of the value of the business itself.

For instance, no matter how much you loved Walt Disney (NYSE: DIS  ) studio's Marvel hits like Iron Man 3, or its iconic Pixar franchise, this isn't enough reason to invest in the stock. In fact, not even Iron Man 3's $1 billion in global box office sales in less than four weeks offers meaningful context for a well-reasoned investment.

A closer look at Disney's business reveals that the company's studio entertainment segment accounted for just 7.2% of its 2012 operating income. Disney's largest contributing business to its bottom line is its media networks division, which accounted for 66% of the company's 2012 operating income. In fact, ESPN alone contributes far more than the company's entire studio entertainment segment.

Don't anchor to historical prices
What a stock did yesterday has nothing to do with its value today. In other words, just because a stock appreciated 100% over the last 12 months, it doesn't mean you missed an opportunity. Likewise, the price you paid for a stock (tax strategies aside) should have no affect on your decision about whether or not to buy, hold, or sell a stock today. In fact, yesterday's price swings -- no matter how large or small -- have zero relevance in estimating the value of a stock today.

So, why would investors give any weight to historical price swings, or to the price they paid for a stock in their investment decisions today? They are suffering from the anchoring effect. According to Daniel Kahneman:

It occurs when people consider a particular value for an unknown quantity before estimating that quantity. What happens is one of the most reliable and robust results of experimental psychology: the estimates stay close to the number that people considered -- hence the image of an anchor.

When investors give in to the anchoring effect, their estimates of a stock's value today are unnecessarily affected by historical price information. For instance, here are three common ways price history can sway our investment decisions today:

  1. A stock could be viewed as a bargain simply because its stock has recently plummeted.
  2. A business could be viewed as poor because its stock has performed poorly lately.
  3. A stock may appear overvalued simply because its stock recently appreciated by leaps and bounds.

The reasoning behind each of these scenarios could negatively impact investment decisions. Value is value, no matter what the stock price did in the past. So ignore those 52-week summaries, and make a decision based on quality analysis, not price movements.

Easier said than done
Listening to Kahneman's investment advice is easier said than done. I know that I've fallen prey to these biases multiple times. Even so, awareness of our tendencies to give too much weight to our gut and historical prices is, at least, a start in the right direction.

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