Most versions of economic theory assume humans are rational beings who will make the best decisions given the facts of their current circumstances. Unfortunately, theory is not reality. People commonly make financial decisions based on irrational and inefficient cognitive biases and other psychological factors that ultimately influence fluctuations in the public equity markets.
To help avoid falling victim to their traps, investors must first consider how and why these biases occur. Following are six tenets of behavioral finance that should be avoided at all costs.
Anchoring is a natural tendency to make assumptions or judgments based on points of reference that individuals already know, even if those details are not relevant to the decision at hand. For example, an executive who stays at a specific hotel brand for business travel may rely on that reference point when selecting a hotel for a family vacation. In this case, anchoring makes perfect sense.
In the investment world, however, anchoring may not always be sensible. Consider the investor who owns stock in ABC Typewriter Company and continues to buy additional shares below his or her initial purchase price of $100. The investor expects the stock price to eventually revert to its original value, which, in this example, is the “anchor” on which the investor makes a purchase decision. The problem with this type of thinking is that it does not consider changes that may occur within the company or its industry. For example, with the invention of the personal computer, ABC’s stock may never again reach $100.
Mental accounting is the tendency to treat and value money differently based upon subjective criteria, such as how it was received, which can lead to irrational decision making. For example, it is not uncommon for people to think of inheritances, gambling profits and tax refunds as “free money” they can use to treat themselves to pricey gifts that they otherwise would not purchase with the money they earn from their jobs. Not only does this line of thinking discount the fact that a tax refund actually is the return of an interest-free loan taxpayers give to the government, it also has the potential to impede investors’ long-term investment goals.
While some investors will sell losing investments at a gain to lock in those profits, others will hold onto those investments with the hope they will recover enough to be sold at a gain at some point in the future. This tendency to hold losers and sell winners is called the disposition effect. To illustrate, consider an investor who in the early 2000s sold stock in Apple to lock in an immediate profit without any consideration of how the company may perform in the future. Today, that investor would likely regret his or her previous decision. Instead, decisions to hold, sell or buy an investment should regularly be assessed based on timely facts rather than an investor’s past experience of gains and losses.
Sometimes investors are so set in their beliefs that they refuse to listen to opinions that contradict their own (cognitive dissonance), and they only pursue evidence that supports their own views (confirmation bias). Both of these behaviors can negatively affect investment decisions. Such is the case with investors in ABC Typewriter Company, who enjoyed above average returns during a 15-year period. As the company struggled against the competition of personal computers, its stock stumbled, leading many financial advisors to recommend investors sell their shares.
As indicated in the hotel example above, many people make decisions based on their past experiences. However, when this bias is applied to investments, people can miss out on significant wealth-building opportunities. For example, a U.S. investor whose portfolio is made up entirely of well-known domestic companies will forgo the potential returns they could yield in foreign markets and emerging market, which make up more than half the world’s market capitalization. This lack of diversification also increases investors’ risk profile, making their portfolios far more sensitive to U.S. market volatility.
About the Author: Shane Phillips, CFA, CAIA, CFP ®, is a portfolio manager with Provenance Wealth Advisors (PWA), an Independent Registered Investment advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs and a registered representative with Raymond James Financial Services. He can be reached at the firm’s Fort Lauderdale, Fla., office at (954) 712-8888 or via email at firstname.lastname@example.org.
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Shane Phillips, CFA, CAIA, CFP ®, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors + CPAs. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory and Financial Planning Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
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There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk, and you may incur a profit or loss regardless of strategy selected.
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Posted on October 4, 2022