Behavioral Economics 101

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There are many forces and players that canseparate you from your money on Wall Street. But our greatest financial enemy is often ourselves.

Behavioral economics, and its sub-field behavioral finance, endeavor to study how we make decisions about money, and other life challenges, when faced with uncertainty and risk.

This has been a passionate area of interest for me for over 20 years, ever since I first walked on the trading floors of Chicago's commodity and futures exchanges and watched the good, the bad, and the ugly among professional speculators.

Your Brain Wasn't Made to Trade

That's a bold statement. But I made it the central theme of an article I published in 2008 in SFO magazine titled Mental Models of Financial Sabotage . I found common themes between rogue traders, like Nick Leeson who took down Barings Bank in 1995, and other irrational gambling behaviors that most people stumble into in their investing and trading.

And once you dive into the science behind my thesis that "your brain wasn't made to trade," you can see how true it really is.

After studying good and bad traders in the pits, and from Jack Schwager's Market Wizards books, I started finding the literature from two fields of science that proved what smart traders learned and earned the hard way.

Behavioral finance showed how irrational people were through dozens of repeatable experiments that put them in scenarios of risk-taking and uncertainty where decisions had to be made.

The other science I became fascinated with was neuroscience. The past two decades have produced a wealth of newknowledge about behavior and decision-making because of brain imaging techniques.

Once science looks at people from the outside-in and tries to describe theories that explain our behavior.

The other looks at us from the inside-out. Where the two sciences meet creates a wealth of opportunity for us to become better traders and investors.

How Madoff Made Off with Their Money

That's because we can train our brains to make better, more conscious, less emotional decisions. And we can "take advantage" of the crowd who will continue to make irrational, overly-emotional moves in markets and our favorite stocks.

And while it's true that we won't always be able to avoid those who try to take advantage of us, at least we will have more control over the biggest factors affecting our financial future-our own brains.

When I published my article in July of 2008, I said that the financial rogues and criminals would always be with us - because of our human nature - and no amount of regulation or risk control would prevent all such mishaps. A few months later, we learned of Bernie Madoff.

But even a Madoff disaster is somewhat preventable if people are paying attention to their biases and the facts of how market returns really work.

Train Your Brain, Trade the Crowd!

The video that accompanies this article shares the roots of behavioral finance and the debt we owe to researchers like Daniel Kahneman and Richard Thaler.

The dozens of "cognitive biases" and heuristics (mental short-cuts, or rules of thumb, for decision-making) they have identified may seems like mere theory. But when you read about them, you probably see how true they are in your own experience.

For instance, there is the bias known as anchoring , the tendency to fixate on one piece of information to the detriment of all other facts that should be considered in new decisions.

Pretend you bought a stock at $100 and now it's at $75.

The first decision to buy now leads to a new decision scenario where the investment is down 25% and further information and risk must be either accepted or ignored.

A rational investor might investigate and determine whether the original buying decision was sound, or if new information has changed the risk/reward dynamics such that exiting and taking the current loss now is the best course to prevent further losses.

But a person who anchors the situation primarily to the purchase price, and who is also loss averse (another bias), may freeze and avoid the pain of loss that would come from selling. He or she may also avoid new information and research efforts to uncover criteria for making a new decision about the investment's risk.

If this person does do more investigation, but only seeks out or pays attention to information that supports his original decision to buy the stock, he or she has fallen into the confirmation bias behavior trap.

Now imagine yourself as the investor who has enough self-awareness to be able to swim in shark-infested, irrational waters and where other investors flail about, driven primarily by their emotions. The opportunities are plentiful when viewed that way.

As I've always said to remind myself of what to strive for… "I'm just a surfer looking for the next wave, never blaming or hating the ocean for being itself."

Mind Over Money, the Podcast

Be sure to watch my video and you'll hear me describe a great experiment that identifies another cognitive bias that behavioral researchers call mental accounting .

And join me every Tuesday for my new podcast Mind Over Money where we expose the psychology of investing. Here is a quick ad for my upcoming podcast, and make sure you keep an eye out for our first episode soon!

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the Tactical Trader portfolio.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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