Wednesday, March 11, 2009

Finding the bottom with Behavioral Finance

I was having a debate of sorts with an individual on an online forum about actively managing your portfolio verses passively managing your portfolio. During the discussion I explained that I use Behavioral Finance to decide when to change my allocation.

Below is an explanation of behavioral finance from

"Behavioral economics and behavioral finance are closely related fields that have evolved to be a separate branch of economic and financial analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns and the allocation of resources.

The field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral Finance has become the theoretical basis for technical analysis. [1]

Behavioral analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases towards promoting self-interest."

I use behavioral finance along with other information to help me find the top and bottom of the market. I can do this because I talk to many individuals a week about there investments. I start to see patterns in the questions and behaviors of investors and get an idea if we are near the top, bottom or still have further to go in either direction.

Let me give you some examples. In late 2004 and early 2005 many of the people I talked to who sold there stocks back in the bear market of 2000-02 were telling me that they did not want to get back into stocks until the market started doing better. The S&P returned 28.7% in 2003 and 10.87% in 2004. The market recover was well on its way, yet I was meeting people who did not realize it. At the time I was thinking about reducing my equity position but from talking to individuals and realizing that the turnaround did not hit the average American I held on to my stocks.

In 2006 everyone I talked to wanted to buy and sell real estate. That is one signal we could be near the top. Think of gold right now. Then I started to hear people talk irrational, which is when I start to think about taking action. Several people I talked to made the same statement, “you can never lose money in real estate”. So in 2006 I put one of my investment properties up for sale and realized that the slow down had all ready begun.

So the question is, using behavioral finance are we at the bottom. It is harder for me to tell this time around because no strategy will work if the financial system is broken. I do have some signs that make me optimistic that we are nearing a turnaround. One sign is the local news cashing in on the crisis with stories like, “Recession Sex” brought to you by Fox news of course. I have not met with an investor in weeks who wanted to sell their stocks. All I need now is some people making irrational statements. Then there is a more fundamental sign, a record amount of money going into treasury securities. Some people are calling it a treasury bubble and I have to agree.

It is important to point out that I only make slight changes to my allocation like going from 80% equities to 60%. I just take some off the table. This way if I am wrong I do not get hurt that bad. I also want to point out that I  moved all my retirement money into equities when the Dow dipped below 8000 the first time. I did not use behavioral finance but I got anxious.  If I was using behavioral finance I would not of bought.  

As somebody who advises people on investing I still think the vast majority of individuals are best served with a buy and hold strategy with the occasional rebalancing of their portfolio.  Your average worker in a 401K plan just does not want to sell when they see their investments making money and do not want to buy the investments losing money.  

Are you a buy and hold investor or do you actively management your portfolio?