There seems to be an underlying assumption in the markets, whether you read the Wall Street Journal or hear the Fed Chairman issuing assurances from on high. That is, professional investors are very smart people. They always make completely rational decisions based upon the best information available. Despising those pesky emotions, these 150 IQ-scoring-investors always beat the irrational rabble-traders in the markets.

Behavioral Finance: The Psychology of Investing

Perhaps this myth of the uber-intellectual, above-the-fray financier developed in less-relativistic times than ours. Whatever the origin of this philosophy, the foundations have been cracking for some time. Another theory has arisen from the crevices of purely rational models of the markets. It’s called “behavioral finance”.

‘Behavioral Finance’ is a field of study devoted to understanding the psychological mindset of investors. Taking into consideration a host of factors besides P/E ratios and Fibonacci Retracements, Behavioral Finance seeks to understand the emotional makeup of investors. Approaching human emotion scientifically, students of Behavioral Finance seek to understand the minutia of investor passions, then exploit those weaknesses for profit.

Benjamin Graham — Early Adopter of Behavioral Finance

Behavioral Finance is not exactly new. Benjamin Graham, one of Warren Buffett’s mentors, first exploited these market passions to the benefit of his trading account. Robert G. Hagstrom said:

“Graham’s conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market.”

Could it be? Despite the edifice of aptitude from their newly-minted Columbia and Wharton MBAs, are most professional investors simply addicts of two vices: fear and greed? Beneath the veneer of $5,000 suits and $10,000 watches, is Wall Street human after all. Maybe so. But the same emotions that run rampant in lower Manhattan also affect us regular folks too.

How Behavioral Finance Works In Real Life

Step outside yourself for a moment. Let’s observe one of your typical trades as an investor. You’ve done your research and you’re convinced this particular stock is the best place you can put your hard-earned money to work for you. You’ve considered everything that could happen and you’re confident about this company. You’re calm, collected, and rational — AND READY TO MAKE A BOATLOAD OF CASH!! — for purely intellectual satisfaction, mind you.

Notice how the greed emotion lies just under the surface of an otherwise staid business transaction. This is the same emotion that Behavioral Finance practitioners seek to exploit in you, and in hundreds of thousands of others who feel the same way about a particular position. Coming from a different angle, one site explains another aspect of that same trade…

“People often see other people’s decisions as the result of disposition but they see their own choices as rational. Investors frequently trade on information they believe to be superior and relevant, when in fact it is not and is fully discounted by the market…On one side of each speculative trade is a participant who believes he or she has superior information and on the other side is another participant who believes his/her information is superior. Yet they can’t both be right.”

How do you like that? Every time you buy a stock thinking it will go up, there’s another guy out there shorting the stock thinking it will go down. Not too reassuring when you think about it.

No doubt Behavioral Finance could teach us some powerful insights about investing. If we took the time to consider psychology of the Street, we would be much more aware of a very emotion-driven market, and perhaps even how to use the rampant sentiment to our advantage. But before I think any more about this, let me first place this trade.

I’m gonna make a KILLIN’ on this uranium stock!!!