Behavioral finance is a relatively new but growing field of study that applies behavioral psychology to economic decisions to help understand why rational people can often make irrational decisions when it comes to money and investing.
DALBAR, a leading financial research firm, produces an annual report comparing stock market returns with average investor returns. Their most recent study shows that over the last 30 years, through December 31, 2016, the S&P 500 has produced an average annual return of 10.16%. However, over that same period, the average equity fund investor has earned only 3.98%.
Behavioral finance seeks to explain this difference by examining investor behavior. In this post, we’ll examine five of the more prevalent behaviors that can affect how people make decisions and how those decisions might affect the investment returns they generate.
1) Loss Aversion
It has been well documented in the sports world that the pain of a big loss lasts much longer than the euphoria that comes from a big win. When applied to investments, loss aversion explains an investor’s predisposition to avoid taking losses, even at the expense of sacrificing gains. Some studies have suggested that losses are twice as powerful, psychologically, as gains. This unwillingness to accept losses often causes us to hold on to losing investments too long, hoping that someday the investments will bounce back.
Anchoring refers to a tendency to fixate on a particular piece of information while ignoring other information that may be just as relevant to the situation or decision-making process.
For example, an investor may anchor on a previous portfolio value and then constantly compare the current value to that previous (usually higher) value. Another example occurs when we are buying a used car. We may anchor on only a single piece of information, such as the odometer reading, to value the vehicle and neglect to consider how meticulously maintained the engine and transmission were.
Anchoring can also come into play with loss aversion. For example, when we anchor on the price we paid for a security, and refuse to sell despite its poor performance, we may be fixated on getting back to break even (avoiding a loss) while ignoring the real reasons for the decline.
Overconfidence is fairly self-explanatory. Essentially, it’s the erroneous belief we are somehow smarter and more capable than is actually the case, and it can cause us to set unrealistic expectations regarding the outcome of a particular effort.
One of the clearest examples would be when you ask someone if they think they are a good driver. Studies show 82% of people think they are among the top 30% of safe drivers!
As it relates to investing, overconfidence is what makes us think we are better at spotting the next hot stock or investment trend. It could also lead to inadequate diversification as you think you know what stock or asset class is positioned to outperform.
An overconfident investor typically trades more frequently thinking he has better information than other investors, and this frequent trading can often lead to subpar performance due to increased commissions, taxes, and losses.
4) Confirmation Bias
We are guilty of confirmation bias when we seek out information, facts, and opinions that support what we already believe and ignore or discount information, facts, and opinions that are contrary to our belief. Confirmation bias is frequently seen in political arguments.
When it comes to investing, confirmation bias can cause us to act without considering all available information. For example, if you own a mutual fund that is concentrated in technology stocks, you are likely to give an unfair weighting to good news you read about the outlook for technology while ignoring any negative things you read.
The flip side is true as well. You may believe that a certain investment is headed for trouble and not be open-minded to favorable news which could cause you to miss out on an opportunity.
Herding is just like it sounds – it’s doing whatever everyone else is doing. It’s a form of group-think. It causes investors to gravitate to the same investments almost solely because many others are investing in those stocks. The fear of missing out is a primary component of herding – no one wants to miss out on something everyone else is talking about.
As investors, this behavior can often cause rallies or selloffs based on hype despite little fundamental evidence to justify the performance of the underlying investment. It tends to be the primary cause of investment bubbles. Herding may also lead us to buy investments that are not appropriate for our particular financial goals or risk tolerance.
These behavioral biases are very difficult to overcome even when we are aware of their existence as they are largely hard-wired into our brains. When investing, it is important to be objective and focus on the long-term while blocking out the noise of the media, stock market gurus, and even well-meaning friends and family.
It is equally important to focus on the data and actively seek out contrary data and ideas to challenge our current thinking. It typically makes sense to trade less frequently, and one of the best ways to accomplish this is to have strict trading rules, such as selling an investment if it drops by a certain percentage or not buying an investment if it has recently risen by a pre-determined percentage. Noted behavioral economist Richard Thaler of the University of Chicago summed it up perfectly when he was recently quoted as saying, “Don’t look at it. Only read the sports pages.”
Keep an Emergency Fund
The unexpected happens, but you can do your best to prepare for it. Maintaining an emergency fund to cover at least six months of living expenses can help you in the wake of job loss, injury, illness, or unplanned home repair. It also can provide peace of mind knowing that your family could remain financially sound in the face of life’s surprises.