Thursday, January 29, 2015

The Psychology of Markets

As the blog evolves, it will be a priority of ours to touch on as many aspects of investing and trading as possible.  We'll certainly be more educated on certain topics than others but hopefully those instances will serve as great learning opportunities. In an ideal scenario, this will be a community full of productive dialogue and interaction.

With that in mind, we intend to dedicate considerable space to the study of behavioral finance and the psychological elements of investor decision making.

Legendary value investor Ben Graham (also known as Warren Buffett's mentor) once said, "the investor's chief problem - and even his worst enemy - is likely to be himself."  Those cautionary words are just as, if not more, prevalent today than when Mr. Graham first spoke them more than a half century ago.  With the relentless amount of news flow and data available to today's investor, it comes as no surprise that so many struggle with managing their emotions and resisting impulse when making investment decisions.

Behavioral finance is a relatively new field of study in the investment universe.  For decades now, a great majority of the advice that is sold and delivered to investors is grounded in the notion that the market is entirely efficient and rational.  The Capital Asset Pricing Model and the Efficient Market Hypothesis were the backbone of finance academia and wealth managers.  These theories were laid out under the assumption that investors were, for the most part, rational in their decision making.  While admirable and neat for a classroom setting, any participant in the real world securities markets knows that irrationality, emotions and biases show themselves on a daily basis.

No matter their skill level or wealth, every investor has at some point has fallen victim to an emotion or bias and made a poor investment/trade because of it.  This is an unavoidable fact of investing but something that can also be minimized by developing a process that is adhered to strictly.

We intend to explore behavioral finance and its many branches in an effort to become better money managers.  We see it as a great way to learn - to highlight and reinforce good habits while providing the chance to expose and eliminate the bad.  Being aware of one's emotions and potential biases is absolutely critical in their growth as an investor and it's a constantly evolving process.  Every day brings about a new set of potential influences.  For example, while slightly extreme, one stain on our record was our extreme pessimism as the market bottomed in early 2009.  During that period we became so focused on further risk to the downside that we lost sight of any other potential outcomes.  We were guilty of actively seeking negative market commentary that jived with our bearish stance.  While this made us feel safe in the short term by confirming our biases it proved to be an unhealthy trait and we missed huge opportunities at the March bottom because of it.  This is just one example.  We've had some since and we'll absolutely have more in the future.

So as active investors we really need to focus on not allowing ourselves get too bullish or bearish. We must constantly challenge our current of view of trends and positions as a means of removing our biases.  It's simply a game of devil's advocate while waiting for price to either confirm or invalidate our research.  Even the best investors will have their share of poor trades, terrible trades even, but one of the key components to their success is their ability to manage their emotions and biases the great majority of the time.

We'll be revisiting behavioral finance topics frequently.  Feel free to join in on the conversation.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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