Hello Tigers! In the last lesson, we went through what risk aversion and loss aversion are, shedding light on the decision-making processes our brains undergo during investments. In this lesson, you can learn some practical behavioral finance strategies to get a better understanding of behavioral finance. Let’s get started!
What is a behavioral finance strategy?
In behavioral finance strategies, investors can use other investors' psychological biases and market inefficiencies to develop investment strategies. This means taking advantage of mispriced stocks before most investors realize their mistakes, investing in those that are either undervalued or overvalued. Once market prices return to a reasonable level, you close your positions promptly to make a profit.
In simple terms, behavioral finance strategy is about profiting from people's mistakes.
It sounds easy, but in reality, using behavioral finance strategies effectively requires meeting the following three conditions:
Three conditions for using behavioral finance strategies
1. Waiting for investors to make mistakes
The first step is to exercise patience and wait for other investors' mistakes.
In market trading, most investors make mistakes in various aspects of cognition, decision-making, and execution. Their mistakes are often emotional and influenced by price fluctuations. For example, buying when stock prices are overvalued and selling when they are undervalued.
Finding other people's pricing mistakes is a prerequisite for behavioral finance trading strategies.
2. Investing in the opposite direction of mistaken investors
Secondly, take actions contrary to those of misguided investors.
The adage "be greedy when others are fearful and be fearful when others are greedy" encapsulates this concept. Stocks that enjoy widespread popularity and easy purchase tend to be overvalued. Hence, in behavioral finance trading strategies, we should divest from these stocks.
Stocks that face widespread selling and disdain from the majority often indicate undervaluation. Therefore, Consequently, these stocks are commonly incorporated into behavioral finance–driven trading strategies.
3. Trading when prices are irrational
Thirdly, in the long run, prices tend to converge towards rational levels.
If undervalued stocks remain undervalued forever, and overvalued stocks remain overvalued forever without correction, the strategy won't be profitable. Therefore, the more irrational the price, the more likely you are to find an "opportunity."
A common behavioral finance strategy: long-term reversal strategy
Now, with these three prerequisites in mind, you can grasp this common behavioral finance strategy, the long-term reversal strategy, more easily.
What is a long-term reversal strategy?
In simple terms, the long-term reversal strategy is :
"What goes up for too long must come down, and what goes down for too long must go up."
Therefore, the logic of this strategy is to buy sectors that have been falling for too long and are basically ignored.
One thing to note here is that, according to the long-term reversal strategy, the correct approach is not to buy stocks that have just fallen, but to buy stocks that have been falling for a long time.
An illustrative example of a long-term reversal strategy
A widely cited illustration of long-term return reversal originates from academic research examining investor overreaction in equity markets.[1] Using historical data from the New York Stock Exchange (NYSE) covering the period from 1926 to 1982, researchers constructed portfolios by ranking stocks based on their cumulative performance over the preceding three years. Stocks with the weakest past performance were classified as “losers,” while those with the strongest performance were classified as “winners.”
In the illustrative strategy, an equally weighted portfolio was formed by taking long positions in the lowest-ranked stocks and short positions in the highest-ranked stocks, with positions held over subsequent multi-year horizons. Empirical results showed that the previously underperforming stocks, on average, generated higher subsequent returns than the prior winners. The return differential between these two groups was economically meaningful, translating into a positive long-short premium on an annualized basis over the sample period.
Among many technical analysis indicators, the "what goes up for too long must come down, and what goes down for too long must go up" trading precept is arguably the simplest price rule. Therefore, trading strategies often stem from very intuitive, straightforward insights and don't require overly complex indicators.
The long-term reversal strategy of "buying low and selling high" exploits investors' overacted behavioral biases in finance, which can cause stocks to be over- or undervalued. Through this strategy, profitable trades are made by trading against these overreactions.
In the end
With that, this lesson on behavioral finance strategies comes to an end. Did you find it quite straightforward?
Indeed, behavioral finance strategies primarily revolve around capitalizing on "counterintuitive" and "unconventional" approaches, and the corresponding operational strategies are typically straightforward.
In the upcoming lesson, you can learn more about behavioral finance strategies applied to financial reports, offering you a fresh perspective on interpreting financial data.
Want to learn more about investing? Keep an eye on Tiger Brokers’ learning centre:
https://www.itiger.com/sg/learn/LESSON
Reference
[1] Available at: https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1985.tb05004.x
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