Behavioral Economics and Investing

[adios]

http://www.sacbee.com/24hour/business/story/697649p-5163976c.html

In the preceding link one of the Nobel prize winners in economics for his work in behavioral economics is interviewed. In a nutshell economic theory is based on individuals acting in rational self interest. Thus a lot of economic literature is devoted to utilizing game theory (Man I glossed over a lot of detail there /forums/images/icons/laugh.gif). Behavioral economics from my understanding states that there is a great deal of irrational behavior. Of course as poker players we all know that irrational behavior can be exploited. What this article seems to advocate is optimal strategy in the market rather than an exploitive one. Now that may be the case but if investors are behaving irrationally it seems to me that an exploitive strategy is more profitable. I'm also left with a nagging thought. Now I enjoy a lot of issues related to valuation and investing as intellectual excercises. So I get a lot of satisfaction from learning about it. However, Sklansky posts here right after the Martha Stewart scandel went public and advocated buying options on her stock. He made probably 8 fold on his gamble with limited downside. His recommendation was made as a way to exploit irrational behavior. I'll just leave it at that and see if there are comments.

[Wildbill]

Economist wrote an article about two people, Felicity Foresight and Harry Hindsight. Felicity invested perfectly each year, picking the asset class with the highest return, she has $13 quadrillion dollars in 103 years. Harry Hindsight invests in the best performing classes now, after they had the big year. They didn't say what he would have now, but I am sure it isn't much. They made the point that the average investor is much closer to Harry than they should be. Of course this is all theory, no one picks things this way, but it doesn't illustrate the point well. The average investor still has a big stake in the market and all too often they chase the hot ideas with no clue of why or when they will get out. While there is something to be said for momentum, we all know investments that maintain it even for 2 or 3 years are rare, yet ask the average investor, often the guy sitting in the cube next to you, and he invests just that way. Look right now, its an unending trend of people taking their discretionary investment money and putting into housing, the best performing assets for a couple of years. Does this really make sense? I think most investors would do well just to see what didn't perform well last year and invest in them next year. Most investments will cluster in the middle, but the things on the fringes are the ones most likely to change course over the next 12 months.