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Game Theory, Behavioral Finance, and Investing: Part 5 of 5

In the first four parts of this article, I have discussed a number of well-known behavioral biases that cause investors to make decisions that are, to put it kindly, less than optimal.  In this final installment, I summarize how best to avoid these costly traps.

As these blog posts have been published over the past couple of weeks, the issues are much in evidence.  Apple (AAPL), long the darling of the market, has lost favor and Groupon (GRPN) seems to be following a relentless downward spiral.  Surely many investors in Groupon must be asking themselves how they could possibly have seen the company as a good bet.  Apple stock, which was trading at $700 in mid-September, is currently at $544, a decline of 22% in two months.  The news that has come out on Apple does not seem sufficient to justify such a broad shift in the market’s consensus as to the long-term value of Apple as a company.  And, of course, we have the poster child of behavioral bias: Facebook (FB).  How is it possible that the market’s consensus view of the share value of such a widely held company could be almost 50% below its first day closing price of $38?  As Warren Buffett is quoted as saying, in the short-term the market is a voting machine and in the long-term the market is a weighing machine.  When voting overwhelms weighing, investor psychology is dominating.

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