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Summary Most of us are held back by our behavioral barriers. Knowing them helps you to understand why markets behave as they do. Anchoring and the bandwagon effect are one of the most important. If you are not happy with your investing returns, then you can basically find fault in two areas: Your knowledge of investing, or your behavioral barriers. This article will go through the most common behavioral barriers that you need to understand before you can climb over them towards greater wealth. I have long believed that investment success requires far more than intelligence, good analytical abilities, proprietary sources of information, and so forth. The ability to overcome the natural human tendencies to be extremely irrational when it comes to money is equally important. Warren Buffett agrees, commenting that, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” The following text is taken and modified from my master’s thesis that focused on value investing and behavioral finance. If you want to read more on the subject, two excellent books to read are Thinking, Fast and Slow and Beyond Greed and Fear . For even deeper knowledge on the matter, you can look for articles written by people named in the following text. Behavioral financial experts basically do not have much faith in the rationality of investors and therefore are against the idea that markets are efficient. If it was, then value premium would be easily explained by the relationship between risk and return. Lakonishok, Shleifer and Vishny write that, due to irrational behavior, the market prices value stocks lower and growth stocks higher. Naive investors typically overreact to the stock market related news and forecast the same growth far into the future. Because of this type of actions, they enhance the effect that might have already been taking place. In simple cases, purchase happens because stock price has gone up, and selling happens because price had gone down. But, as a simple example, this can be due to one large investor selling or buying a large amount at the same time, resulting in a price change. Some investors might take this as a sign of change and hop on or off the train. This type of investor behavior can also be explained, at least partly, by agency issues. Many professional investors might be under pressure from their bosses, clients, or due to peer competition they are forced to deliver quick results. Therefore, they are being forced to favor short-term profits over better quality investments that require longer holding periods. This type of investment pattern is often seen among institutional investors and even CEOs. Also for any professional investor, it is greatly easier to recommend the purchase of well-doing growth stocks that have a good track-record, than value stocks with a long period of negative returns. Representativeness A financial example to explain representativeness is the winner-loser effect that was proven by De Bondt and Thaler. They find that stocks that have been biggest winners during the past three years do much worse than the stocks that were the biggest losers during that same timeframe. De Bondt proves that as analysts make long-term earnings forecasts, their views tend to be biased to the direction of recent success of the firm. Meaning that analysts are overly optimistic about recent winners and feel pessimistic about recent losers. Also, De Bondt finds that market predictions are overly optimistic (pessimistic) after three-year bull market (bear market). Therefore, it becomes quite clear that analysts’ recommendations are not particularly useful when they can be linked to representativeness. One reason for this behavior is that people underweigh evidence that disconfirms their prior views and overweigh confirming evidence (Shefrin). Overconfidence In simple terms overconfident people overestimate their skills to complete a difficult task and therefore are surprised more often than they anticipated. Clarke and Statman proved that people are overconfident. They showed this by simple questions such as: How long is the Nile? Give your answer with minimum and maximum so that you are 90 percent confident that the actual length is inside your low and high guess. They asked this type of questions in survey form and found that most people are not well aware of such things but are overconfident as their high guesses were often very low compared to the actual numbers. So when people are overly confident they set too narrow confidence bands in such questions and just like financial analysts, are surprised by the results. One way to understand this is to think of a stock you were following and should have sold much earlier than you did, but you didn’t because you kept believing it can’t go lower. Anchoring and Failure to Adjust Mendenhall and Abarbanell and Bernard find evidence that analysts underreact to earnings information. Even when they get to adjust their forecasts based on new information (such as a profit warning), they are still underreacting to actual results. Their work shows that analysts fail to appropriately tweak their forecasts. What happens is that, as analysts anchor their expectations to previous information, then surprises that happen are even larger in the end. This failure to adjust expectations can then lead to value stocks and large price jumps. Psychology and limits to arbitrage Arbitrage refers to a situation where investors are able to gain a riskless profit due to the market mispricing an asset. By buying an undervalued asset and cashing the profit when prices have returned to normal. In reality the risk is that the market can continue to misprice the asset even further. This is called as the “Noise trader risk”, introduced by Long, Shleifer, Summer and Waldman. Noise trader risk happens when irrational investors keep moving the price of an already mispriced asset to the same direction, despite the actions of one or more rational investors. Also transaction costs add more risk to the equation therefore limiting arbitrage behavior. Mental accounting A typical investor does not see every euro that he possesses as being identical. Mental accounting theory helps to explain why it is quite typical for investors to divide their money to “safe” money invested in low-risk assets, while investing their “risk capital” very differently. Once money has been placed in one mental account, it no longer is a direct substitute for money in another mental account. Mental accounting theory tries to understand this psychology of decision making. Mental accounting has three components, according to Thaler. First, outcomes are apprehended and experienced. Based on this, decisions are made and later evaluated. Second, activities and sources are categorized. For example to invest or to save and also the use of these funds for spending such as housing and food. Lastly, these accounting activities are rebalanced daily, weekly, monthly or so depending of that person’s personal preferences. Gross claims that in cases where a client’s investment is at a loss a stockbroker can keep its customers by using words “Transfer your assets”, instead of referring to selling and buying. Selling would lead investors to acknowledge their losses, but now they merely transfer their money from one mental account to another. Myopic loss aversion People have stronger reaction to losses in their wealth, than they do to increases even if gains are bigger than losses. Psychologically losses are taken approximately twice as heavily compared to gains. A myopic investor is defined as a person who tends to make short-term decisions over long-term ones, and often evaluates his/her losses and gains. An example of this would be to follow a myopic and a non-myopic investor. Myopic investors would likely avoid stocks and invest in assets such as safe and stable government bonds. If he had stocks, he would constantly check the market and, in case of a loss, feel it emotionally as very painful. Therefore, myopic loss-aversion leads investors to choose portfolios that are overly conservative. While a non-myopic investor would not check the market as often and would be comfortably unaware if his wealth happens to take an occasional downhill. Therefore, he prefers long-term investments with better returns over safer government bonds. (Thaler, Kahneman, Tversky and Schwarz) Framing As defined by Tversky and Kahneman, the term “decision frame” means the acts, outcomes and contingencies that a decision maker associates with a certain choice. This one frame depends on personal characteristics, norms, habits and also on how the problem is presented. As problems can be presented in many different ways, that can also change the outcome of framing. According to Tversky and Kahneman, “Individuals, who face a decision problem and have a definite preference, might have a different preference in a different framing of the same problem, and are normally unaware of alternative frames of their potential effects on the relative attractiveness of options.” Prospect Theory Developed by Tversky and Kahneman, it is an alternative theory to analyze decision making in situations that contain risk. Prospect Theory (PT) focuses on gains and losses instead of wealth. Also, instead of using probabilities and risk aversion, PT uses decision weights and loss aversion. An outcome is called a prospect, and a prospect includes a decision with some level of risk. Decisions are made in two levels: The editing and evaluation levels. In the editing level, possible outcomes are put in order, according to some heuristic. This can be explained by people looking at the outcomes and they make a mental note of an approximate and possible average outcome. By using that average as their reference point, they’ll then categorize lower outcomes as losses and higher ones as gains. So Tversky and Kahneman state that humans prefer focusing on gains and losses instead of their final wealth. The Bandwagon Effect This is a form of group thinking. With stocks, it refers to a situation when more and more people start to buy a certain stock, the more will follow, therefore increasing the demand more and more. They might do this despite their individual beliefs and opinions, simply because other people are doing it. As more and more people join, those that are still out are under group pressure to “join the fun”. The expression, “hop on the bandwagon” is typically used when this kind of a group effect is happening. Bandwagon effect has two sides to it, according to Shefrin. First, it is believed that a crowd must know something. Second, losers don’t want to be alone. In the case of negative returns, the pain of regret is eased by the knowledge that many others made the same mistake. This theory helps us to understand why growth and value stocks perform as they do. As more and more people abandon the stock, it becomes a value stock when enough people have “left the bandwagon”. Growth stocks are the opposite until they reach their peak when the first people start jumping off. The most rational investors should be the first ones to jump on and off the stock. Conclusion The world is full of information to learn. The hard part is learning to control yourself. When you understand and remember these behavioral barriers, you are above the average investor and closer to greater wealth. The bandwagon effect is one of the most basic ones, but also the most important one, in my opinion. It explains the market behavior during the most critical times, during a bubble and a crash. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.