Behavioral and Historical Finance

Jason Zweig Your Money and Your Brain

• Neuroeconomics
  • A monetary loss or gain causes a biological change that has profound physical effects on the body
  • Neural activity of someone making money in investments are indistinguishable from someone high on cocaine
  • After 2 repetitions of a stimulus, the human brain automatically, unconsciously, and uncontrollably expects a 3 repetition
  • Once people conclude that an investment return is predictable, their brains respond with alarm if the pattern is broken
  • Financial loss is processed in the same areas where we respond to mortal danger
  • Anticipating a gain and actually receiving it are expressed in different areas. Helps explain why money does not buy happiness
  • Expecting both good and bad events is often more intense than experiencing them
• Greed
  • There is only one sure thing on Wall Street. And this is there are NO sure things
  • Lightning seldom strikes twice
  • Lock up your “Mad Money” and throw away the key. If you can't stop yourself from gambling in the market, then limit the amount
  • Control your cues. Turn off CNBC
  • Think twice before making any decisions. Calm yourself down
• Prediction
  • Our incorrigible search for patterns leads us to assume that order exists where there is non
  • Whenever you are confronted with anything random, you WILL search for patterns in it
  • People hate randomness
  • If a reward is big enough, it will carry a long-lasting memory that is difficult to break. This is why chart analysts get into trouble because they think they “got it”
  • Investors have a recency bias – what has happened they think will continue to happen, even if it is unpredictable. This causes investors to think that a bull market will continue and a bear market will also. This also causes them to buy the hottest mutual funds
  • Control what you can in the market – don't look for the next Google
  • Expectations – set realistic goals
  • Risk – ask not how much you can gain, but also how much you can lose
  • Readiness – think twice
  • Expenses – keep them low
  • Commissions – keep them low too
  • Taxes – don't day trade, you get hit with short term taxes
  • Yourself – don't try to predict
  • Don't try to predict the market – DCA is a good strategy to prevent this
  • Most mutual fund managers fail to beat the market. Answer to this is to DCA into index mutual funds
  • Correlation is not causation
  • Take a break – if you take a break, it resets your “gamblers fallacy” IE – a coin is flipped 7 times and comes up heads 7 times in a row, the next flip is “due” for a tail.
  • Don't obsess – if owning stocks is a long-term project for you, then following changes constantly is a very, very bad idea.
• Confidence
  • Create a “too hard” pile. Know what you don't know.
  • Measure 2x cut 1x. Have an overconfidence discount of 25% so if a stock according to your valuation is worth between $40-60. Make it $30-45.
  • Don't get stuck on your own companies' stock
  • Diversification is the best defense
• Risk
  • Take a time out. Do not buy or sell an investment on the spur of the moment
  • When the price drops, so does risk.
  • Try to prove yourself wrong. Listen to another person's opinion
  • Know yourself and your risk tolerance
• Surprise
  • If everyone knows something. It is already embedded in the price of the stock
  • High hopes can cause big trouble
• Regret
  • Expecting regret often hurts worse than experiencing it
  • The more you can automate your investing, the better
  • Face your loss.
  • If you have a truly diversified portfolio, then you will guarantee yourself, by definition, that some of your assets will do well while some will do badly. You have to look at the whole portfolio
  • Don't chase hot sectors or stocks. The cure for chasing is to rebalance. Decide on a number and stick with it
  • Rebalancing over the long-term increases returns and lowers risks. It is buying low and selling high
• Happiness
  • If you earn enough cash to live on. Then more money won't make you happier
  • Know that money is a means, not an end in itself
• Summary
  • Take a global view. Look at total net worth, not changes in each holding
  • Hope for the best but expect the worst. Diversifying can keep you from panicking during bad times which will occur
  • Investigate before you invest. A stock isn't just a price. It is a company
  • Never say always. Never put more than 10% of your investments into a single stock
  • Know what you don't know.
  • The past is not the prologue. What goes up must come down and what goes way up usually comes down with a crunch. Never buy an investment because it is going up. Smart investors buy low and sell high
  • If it sounds too good to be true, it probably is. Anyone who offers a high return at low risk is probably a fraud
  • Costs are killers. Trading costs eat up your profits
  • Don't put all your eggs in one basket. Spread out between US, foreign, bonds, and cash. It is not a good idea to invest heavily in industries that your job is tied too. If you lose your job, your stock would be likely to fall also.