Stop. Think. Invest.: A Behavioral Finance Framework for Optimizing Investment Portfolios - Deepstash

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Behavioral Economics Helps In Making Better Investment Decisions

Behavioral economics is the study of how the social, psychological, and emotional facets of human nature play into the field of economics and investing. It represents a combination of cognitive behavioral factors that should be considered when making important financial decisions – such as knowing which stocks to pick, when to sit tight, when to sell or trade, and how much to invest.

Author Michael Bailey has identified steps in the stock-picking process so you can avoid the major pitfalls that have been known to sink even the most seasoned investors.

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Definition Of Investing

Investing is a process that involves the following: looking for new ideas, researching companies, mapping out your long-term expectations, deciding on the timing and size of your investment, making a purchase and analyzing the results, considering when or when not to sell, reevaluating your expectations, and focusing on learning and improvement.

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The Libertarian and Paternal approaches.

Being libertarian means being open to all ideas and free of opinions or biases that might blind you from the perfect investment opportunity. After looking at things with an open mind, you’ll need to narrow them down by exerting a certain amount of paternalism. The process here is about narrowing things down. Eliminating choices. Giving yourself fewer options.

Bailey recommends seeking out stocks that have the potential to beat, or outperform, the market, Like a company that has changed management, made a sizable acquisition, created a new division, or perhaps launched a new product campaign.

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Example

In 2016, Bailey took an open-minded, libertarian approach to looking for new long-term investment ideas. This led him to explore options like cloud computing, cyber security, and self-driving cars. From there, he shifted to a paternalistic approach and took a close look at these three different ideas. Self-driving cars still seemed a little too high-risk at the time. As for cloud computing, he already had holdings in Microsoft and Google – so he felt he had this trend covered. He narrowed it down to cyber security, an area that would likely continue to have long-term relevance in the market.

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Research Your Options

Researching your options and getting to know the details of the businesses you're considering is a crucial part of the stock-picking process. Make sure you don’t end up being blinded by the inside view. It be can incredibly useful to talk to people who are part of the industry. But you don’t want to get so far inside that you lose sight of your impartiality. So remember to always take a step back and consider the outside view before drawing any conclusions. Don’t hesitate to get out of your comfort zone and dig deep when researching your options.

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“Availability Bias” And “Risk Bias”

Safe bets are often bad investments. This ties into the availability bias. A safe bet is likely one that everyone knows about – and if everyone knows about it, that stock isn’t going to beat the market or do much for your portfolio. So a good tip here would be to give yourself a range of risk to choose from – or to find a way to mitigate the risk by broadening your framework. And that’s what risk bias is. once you’re aware of your risk aversion bias, you can take steps to neutralize it!

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“Investment Thesis”

Crafting an investment thesis simply involves writing down your reason for picking the stock you decided upon. What made you choose this stock? What are your expectations? This is the time to exercise your rationality and lack of bias. Be clear and practical, and don’t let inside views or bold forecasts skew your judgment. A good investment thesis is priceless. It’ll not only help you figure out the right stock to pick, but will also help you make a number of other important decisions – like when to buy or sell.

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“Investment Committee”

Another useful tool that goes hand-in-hand with an investment thesis is an investment committee. This is generally an impartial group of professionals who can help debate the pros and cons of an opportunity and make sure that a thesis or plan is realistic. Of course, groups can also be susceptible to biases and behavioral pitfalls. So when it’s time to debate a decision, the smart move is to break the committee up into smaller groups. Also, it’s important to encourage everyone in the investment committee to be sharp, take notes, make observations, and speak up without fear.

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Your Investment Got Off To a Bumpy Start

There are a number of reasons why a stock could hit a rough patch. One common and unfortunate cause is the media echo chamber. A small, insignificant problem may arise and get reported on – which then causes a significant sell-off. This sell-off can snowball into another news item, which in turn fans the flames of panic even further. If you can recognize this particular feedback loop when it occurs, you’ll gain some reassurance that the initial problem was, in fact, minor – and not cause for alarm.

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Example

In 2007, just before the major global recession, Bailey bought stock in a medical device company called Covidien.

Covidien entered some choppy waters early on as the recession hit, that didn’t necessarily change the thesis. Medical device technology was still on track to play a big role in the future, and Covidien remained in a perfect position to outperform the market. So despite some concerned voices around him, Bailey stayed with the company. And it did indeed outperform for a number of years – before eventually being bought by Medtronic in 2015.

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KENNY ROGERS

You gotta know when to hold ’em, and know when to fold ’em.”

KENNY ROGERS

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Holding your stocks can be riddled with behavioral pitfalls and misleading noise is important. But there are also things to be aware of when it comes to knowing when to fold ’em. 

Avoid the whole “set it and forget it” mindset. You want to focus on a growth mindset, not a fixed mindset. This means recognizing that you can learn from both successes and mistakes and continue to improve every day. You want to set up regular intervals where you reevaluate your investment thesis to see if it needs updating or adjusting in order to reflect the outside view.

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Don’t put all your eggs in one basket. Mix it up. Put together a portfolio that isn’t all low-risk or high-risk, that’s instead a healthy diversified combination. 

from time to time, we all make decisions based on negative feelings like regret. If only we’d done this or hadn’t done that, Figure out what happened and learn from the past rather than get hung up on what-ifs. 

Above all, keep an open mind, continue to learn along the way, and don’t let early missteps scare you off. It might not seem like it at first, but stick with it and you’ll see: investing can be fun!

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Final Thoughts

Biases, fears, and influences both internal and external can cause investors to make bad decisions every step of the way. But here’s some more actionable advice:

Ask yourself four questions when researching potential stock picks.

“Who uses? Who chooses? Who pays? Who profits?

In other words, who’s using the product or the service ? Who’s choosing which products and the services are being offered? Who are the customers or clients paying for these things? And who’s profiting – where is that money going?

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MICHAEL BAILEY

Each and every one of us holds the amazing power to modify our life at any time we decide to do so

MICHAEL BAILEY

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