Behavioral finance is the study of human behavior. Specifically, behavioral finance examines how, and why, human beings make irrational decisions – irrational decisions specific to investing. What are these irrational decisions?
One of the concepts of Behavioral Finance is herd behavior, or performance chasing. With herd behavior, you’re following the crowd; if the crowd makes an irrational decision, you’re apt to do the same. The most common irrational decisions being:
- Buying high
- Selling low
Buying high is purchasing shares of company stock, but only after a recent price run-up. It is the act of jumping onto the bandwagon – once everyone else has done so. With respect to the price you pay per share, consider a shopping analogy: buying high is waiting for the sale end – and then making your purchase. When you buy high, you’re waiting for demand for the investment to be pushed up, up to a price that is beyond reasonable. In short, you’re overpaying.
Imagine wandering around your favorite department store. There is a massive sale – with many products being sold below cost! The deals are so good, that you wonder if the merchandise is any good. “Perhaps,” you think to yourself, “they must be knock-offs. “Or,” you think to yourself, “they must be defective products.” You continue to pace around the store, and watch as items get snatched off the shelf – for what is a screaming deal. After many items have been sold at ridiculous bargain prices, the sale ends. The sale tags come off. All the prices go up. Relaxed that prices are back to normal, you decide:
Now is the time to buy!
Selling low is just the opposite. Selling low means parting with something you already own – but only at a very low price. Selling low is giving yourself a very bad deal, while at the same time giving someone else a really great deal. With selling low, you’re waiting until what you own is out of fashion – at which point you decide:
Now is the time to sell!
[h3]The Why in Herd Behavior[/h3]
Why would anyone do these financially self-destructive things: buy high and sell low? Behavioral finance says that herd behavior exists because:
- individuals are prone to peer pressure: people conform their investment strategy to what other people are currently doing
- individuals are vindicated by the crowd: if everyone is doing it, it is assumed that the strategy practiced universally must be the right strategy
[h3]Be a Contrarian Investor by Rebalancing Regularly[/h3]
Buying low and selling high is contrary to what the lay investor may do – and why the strategy of buying low and selling high could be called contrarian – in investment geek speak. Being a contrarian investor means going against the grain – doing the opposite of what everyone else is doing.
You can be a contrarian investor – profiting off the mistakes of other investors. You can do this by regularly buying low and selling high. In investment geek speak, this process is called “rebalancing.” Rebalancing your investment portfolio should be done on a regular basis (usually annually).
[h3]Your Weapon Against Herd Behavior: the Fee-Only Investment Advisor[/h3]
Herd behavior can cause a lay investor to make poor financial decisions. But that’s where the value of a fee-only investment advisor can help. A fee-only advisor can show you a detour around those typical investing mistakes just described: buying high and selling low. Your fee-only investment advisor can illuminate the path for you – the path for buying low when others are selling low, and selling high when others are buying high.