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, I will introduce some practical behavioral finance investment strategies.
1.What are behavioral finance strategies?
Behavioral finance strategies involve using 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 strategies are about profiting from people's mistakes.
2.Three conditions for using behavioral finance strategies
It sounds easy, but in reality, using behavioral finance strategies effectively requires meeting the following three conditions:
(1) Waiting for Investors to Make Mistakes
The first step for this is to exercise patience and await the mistakes made by other investors.
In 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, in behavioral finance trading strategies, it's advisable to acquire these stocks.
(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."
3.Long-term reversal strategy
Now, with these three prerequisites in mind, let me tell you about a common behavioral finance strategy: the 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.
Nobel laureate Eugene Fama used this principle to develop a trading strategy.
He used data from the New York Stock Exchange from 1926 to 1982, ranked stocks based on their performance in the previous 3 years, bought the 35 worst-performing stocks, and shorted the 35 best-performing stocks. The results showed that using this strategy yielded an average annual return of 8%.
Among many technical analysis indicators, "what goes up for too long must come down, and what goes down for too long must go up" 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' psychological biases of overreaction, which can cause stocks to be overvalued or undervalued. Through this strategy, profitable trades are made by trading against these overreactions.
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, I'll introduce you to behavioral finance strategies applied to financial reports, offering you a fresh perspective on interpreting financial data.
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