Most versions of economic and finance theory take the approach that humans are rational and will make the best decisions given their specific circumstances. Unfortunately, theory is not reality. In reality, humans often make irrational decisions. Often, these choices are influenced by psychological factors that can be explained through the study of behavioral finance.
Behavioral finance “uses insights from the field of psychology and applies them to the actions of individuals in trading and other financial applications”1. Following are six of the most popular theories in behavioral finance and explanations about their impact on both amateur and professional investors.
Anchoring is the natural tendency for an individual to make an assumption or judgement based on a point of reference that he or she knows, even if that detail is not relevant to the decision at hand. For example, a business traveler who has stayed at a specific hotel chain numerous times may rely on that reference point when selecting a hotel for a personal vacation. In this case anchoring makes perfect sense.
In the investment world, however, anchoring may not always be prove sensible. Consider the investor who continues to buy the stock of ABC Typewriter Company below its initial purchase price of $100. The investor expects the stock price to eventually revert back 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 in the company and its industry since the initial purchase price. For example, with the invention of the personal computer, the typewriter company’s stock may not reach $100 again.
Working to remove this anchoring effect from investment strategies and instead focusing on fundamentals and current information should help individuals make better investment decisions based on facts.
Treating money differently based upon how one receives the funds is referred to as mental accounting. For example, investors may view and use money they earn from employment differently than money received through inheritance, tax refunds or gambling profits. Some individuals wait all year to receive tax refunds and think they hit the jackpot once the refund arrives. They often use this “free money” from the government to treat themselves to a pricey gift that they would not have otherwise purchased. In actuality, tax refunds are the return of an interest-free loan taxpayers gave to the government. Using this money for different purposes based upon how it was received over many years may hinder investors’ long-term investment goals.
It is common for individuals to hold losing investments with the hope that those securities will recover enough for investors to sell them at a gain at some point in the future. Conversely, individuals may sell investments at a gain to lock in those profits. This tendency to hold losers and sell winners is called the disposition effect.
For example, consider an investor who in the early 2000s sold stock in Apple in order to lock in an immediate profit without contemplating the company’s future business prospects. In hindsight, this may was probably a poor choice. The decisions of whether to hold, sell or buy an investment should be assessed regularly 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 pursue only that evidence that supports their own views (confirmation bias). Both of these behaviors can negatively affect investment decisions. Such is the case with an investor in ABC Typewriter Company who yielded above-average returns during a 15 years period. As the company struggles against the competition of personal computers, its stock stumbles and many financial advisors recommend an investor sell his or her shares. The investor who fails to take a step back from his or her own biases and avoids opinions contrary to his or her own will continue to hold the stock with the hope that the company can turn itself around.
Many people make decisions based upon past experiences, similar to the selection of the hotel used previously. However, when individuals invest solely in companies, investment products or markets in which they are most familiar, they may be missing out on significant opportunities.
For example, many U.S. investors invest a majority or, in some cases, all of their assets in domestic markets, even though a majority of global GDP and investable assets come from foreign markets2. By making investment decisions based solely on that with which investors are familiar, a large part of the global investment landscape is ignored, and many opportunities may be missed.
It is not uncommon for investors to fall victim to one or more behavioral biases during their lifetimes. However, by understanding and identifying these biases, investors may take steps to minimize their influences on investment decisions and outcomes.
About the Author: Shane Phillips, CFA, CAIA, is a member of the investment team with Provenance Wealth Advisors, an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors and Accountants and a registered representative with Raymond James Financial Services. For more information, call (305) 379-8888 or email firstname.lastname@example.org.
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