Behavioral Finance

In behavioral finance - more so than classical finance theory - computers play an important role in the practical implementation of trading strategies.

In this "game" it's not about an analyst's unprecedented ability to identify an undervalued title by extracting a better understanding of company fundamentals through interviewing corporate managers and analyzing economic market drivers in the respective industry. It's about analyzing the financial market per se. Given that the finance industry is a market of numbers and figures, it's no wonder that one can only grasp the underlying dynamics from analysing them, comparing ratios, moves and momentum, trading volumes and market participants' (mainly brokers) expectations, amongst various other trends.

Ergo, you better are capable of processing thousands/millions of data items at any point in time, and apply the vigorousness to trading (buy/sell) discipline, if you want to out-perform in the long run. Behavioral Finance is not about short-term profits, also not about trying to predict when it is the best time to enter or exit a stock market. We look at the stock market as a system and not at the world (other alternative investment opportunities outside of the stock market).

But why do computers outperform in the long-run against a "gifted" individual investor? It's like in chess: Deep Blue did not win against Kasparov because "he" was more creative or had better intuition. As a matter of fact, he was dumb and could only learn from the past. But he could process by far more strategic outcomes than a human brain at the same time can do, and he was not affected by "human stress" (to perform) and therefore a culprit of "irrational behavior" himself. As long as he had "power" (I mean electricity), he did his job with a discipline like no human being could do. Steven J. Milloy in 1997 wrote about this show-down as follows: "The creation of Deep Blue, in short, is a marvelous human achievement. Its creators deserve our admiration. That it took so many of them so long to combine such awesome computing power in a way that could stand up to one human genius is reason on all sides for humility-an occasionally useful virtue in times such as these."

This virtue doesn't help when things are changing fundamentally. But except for 09/11, things "usually" don't change over night fundamentally. There are signs available from market participants, that the avid "computer trader" can exploit in advance. That's why behavioral finance-related investment strategies cannot make money from "insider trading" or may lose money in the short-term, but by and large the robustness and discipline of the models exploit the weaknesses of the human trading counterparts in the same market.

So, if you are thrilled by this discipline, let me advise you on two prerequisites to "survive" in it: (a) Don't think you're a smart investor, but have the computer make decisions for you. You cannot grasp this discipline without it! (b) Be in it for the long-term. Don't get cold feet, because you lose money in one month of trading or even within a quarter. This is not about day-trading or should I be in the market or not. It's about outperforming other players in the market in the longer-term.

Good luck, enjoy, and endure!