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LFA Updates | January 2015
Investor Psychology
"The investor's chief problem - and even his worst enemy - is likely to be himself."
-- Benjamin Graham (father of modern securities analysis and mentor of Warren Buffet)
Studies by prominent researchers at the intersection (or collision, perhaps) of psychology, economics, and finance have empirically demonstrated that stock prices fluctuate much more than we would expect if they were based on a completely rational market theory. That is, if prices were based solely on the expected receipt of future dividends, discounted to a present value.
One such researcher is Robert Shiller, co-winner of the Nobel Prize in Economic Sciences (2013). He has stated: "The reason markets are volatile is that financial assets are unlike consumer goods; when their prices rise, that creates more demand, not less."
Mr. Shiller has used the phrase "Irrational Exuberance" to describe this phenomenon, and has noted that this behavior by investors has created several "bubbles." He famously predicted two of the biggest bubbles of all time: the dot-com bubble and the housing bubble.
In addition to his empirical work, his survey research asked investors and stock traders what motivated them to make trades; the results further bolstered his hypothesis that these decisions are often driven by emotion rather than rational calculation.
Many others have also devoted their life work to explaining why people make financial decisions that are contrary to their own interests. Daniel Kahneman - the first "non-economics major" to win a Nobel Prize in Economics (2002)-has provided validation that emotion can affect the financial decision making process. Driven by emotional reactions such as greed and fear, investors join in frantic purchases and sales of stocks, creating bubbles and crashes.
By better understanding investor behavior, and by developing the ability to identify one's own psychological weaknesses, it may well be possible to recognize and capitalize on emotion-driven market anomalies. Given the recent volatility in the markets, this topic of emotional decision making seems particularly relevant.
Here then, are mistakes investors may make (adapted in part from Morningstar's Investing Classroom):
1. Overconfidence: The ability to think we're smarter or more capable than we really are, overconfidence is what makes 83% of college students believe they are in the top half of their class. For investors, overconfidence is a detriment when we believe we're better able to spot the next "big thing" than another investor is. Overconfident investors trade more frequently because they believe they know more than the person on the other side of the trade. Trading costs-commissions, taxes, and fees-greatly diminish annualized returns. To combat overconfidence, ask yourself, "What am I missing?"
2. Selective Memory: Frequently considered a byproduct of overconfidence, selective memory allows us to forget painful experiences in the past, including missed investment opportunities. We are able to preserve our self-image by selectively remembering events rather than remembering the past accurately. Incorporating information in this way is well known in the psychology field of cognitive dissonance. Cognitive dissonance posits that we are uncomfortable holding two opposing ideas or behaviors at once, and our psyche will work to correct this. Selectively adjusting our memory of a poor investment choice is one such way to come to terms with cognitive dissonance, particularly if we believe we are skilled traders.
3. Recency Effect: Related to selective memory, recency effect is a mental shortcut that causes us to give too much weight to recent evidence-such as short-term performance numbers-and too little weight to the evidence from the past.
4. Representativeness: Involves looking at a small data set and extrapolating information to draw erroneous conclusions.
5. Self-Handicapping: Perhaps the opposite of overconfidence, self-handicapping bias occurs when we try to explain any possible future poor performance with a reason that may or may not be true. By admitting we didn't spend as much time researching the stock as we normally do, in case the investment doesn't turn out well, we are succumbing to self-handicapping.
6. Loss Aversion: Investors have been shown to be more likely to sell winning stocks in an effort to take some profits than to accept defeat by selling losers. Regret is a big part of loss aversion in that it may lead us to be unable to distinguish between a bad decision and a bad outcome. We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons. In this case, regret can lead us to make a bad decision, such as selling a solid company at a bottom instead of buying more. It's this unwillingness to accept the pain early that might cause us to "ride losers too long" in the vain hope that they'll turn around and won't make us face the consequences of our decisions.
7. Sunk Costs: Like regret, sunk costs is part of the loss aversion mistake commonly made by investors. The sunk cost fallacy states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.
8. Anchoring: The human tendency to rely too heavily, or "anchor," on historical data when making decisions. When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or to its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it. We may cling to subpar companies for years, rather than dumping them and getting on with our investment life. It's costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.
9. Confirmation Bias: Related to overconfidence and anchoring, confirmation bias involves favoring information that confirms our preconceptions and hypotheses regardless of whether the information is true.
10. Hindsight Bias: Also playing off of confidence and anchoring behavior, hindsight bias is the tendency to reevaluate a past decision based on the actual outcome. For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. This type of "knowledge updating" can keep us from viewing past decisions as objectively as we should.
11. Mental Accounting: Most of us separate our money into buckets--this money is for the kids' college education, this money is for our retirement, this money is for the house. This can be very beneficial because earmarking money may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we categorize our funds without looking at the bigger picture. One example of this would be how we view a tax refund. While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously. Since tax refunds are in fact our earned income, they should not be considered this way.
12. Framing Effect: Another form of mental accounting, the framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect our decision. For example, suppose we decide to buy that television after all. But just before paying $500 for it, we realize it is $100 cheaper at a store down the street. In this case, we are quite likely to make that trip down the street and buy the less expensive television. If, however, we're buying a new set of living room furniture and the price tag is $5,000, we are unlikely to go down the street to the store selling it for $4,900. Why? Aren't we still saving $100?Unfortunately, we tend to view the discount in relative, rather than absolute terms. When we were buying the television, we were saving 20% by going to the second shop, but when we were buying the living room furniture, we were saving only 2%. So it looks like $100 isn't always worth $100 depending on the situation.The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments, and to take care not to think of your "budget buckets" so discretely that you fail to see how some seemingly small decisions can make a big impact.
13. Herding: Following a stock tip, under the assumption that other people have more information, is a form of herding behavior.
It is clear that many investors hurt themselves financially by making too many buy and sell decisions for too many fallacious reasons. With all the investment choices out there, it is difficult to construct a well-balanced portfolio if you lack the time, background, and resources to do the hard work that is required.
At Lifetime Financial Advisors, Inc. our years of experience may spare our clients from the agony of buy/sell/hold decisions and from the responsibility for turning an understanding of the macroeconomic backdrop into asset allocation and manager selection. We work full-time, with dogged persistence and patience, and focus constantly and unwaveringly on markets and assets, ceding to managers who possess proven track records. This strategy and philosophy enables us to save clients from making those common investor mistakes. This is one of the greatest services that we provide to you.
The link below will take you to a quick, fun 8-question quiz on investor psychology.
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