Understanding how Behavior Affects our Investing

Written by Nate White, CFA

How does your thinking or behavior affect your investing? After buying a stock, have you ever uttered the phrase, "Now that I've bought this, it's sure to go down," or maybe you tell people to do the opposite when you buy or sell an investment? Over the course of my career I can't tell you how many times I've heard this. Another common situation is when you buy a stock that does nothing but go down, but you cannot bring yourself to sell it. It seems as though everyone has the same mentality, and yet each person thinks they are unique.

When it comes to money, humans can become very emotional. It's interesting that we can make well thought out rational decisions about so many things in life, but when it comes to investing we can be self-destructive. Experiments have proved that when people are presented with ambiguity their emotions tend to take over resulting in poor choices. This is true with investing.

Most people do not understand, fail to gather, or ignore all of the relevant information affecting an investment. The financial markets are extremely complex and dynamic, and make a regular habit of humbling the unprepared. In our frenzied modern society, the constant barrage of information from cable TV shows and the Internet make it that much harder to control our emotional impulses and often lead people to lose money faster.

For the past 50 years the investment profession has been significantly influenced by the notion of the efficient market. The basic premise of the efficient market theory is that all information about financial assets is reflected in their current prices, and no one can gain an advantage through any kind of research. In this world it is your allocation among the varying risky assets that determines your return, as investors are considered to always be rational decision makers. The assumption that investors act rationally and consider all available information is obviously false, not realistic and gave rise to the field of behavioral finance.

Behavioral finance is the study of how emotions and cognitive errors influence investors and subsequent effect on markets. I would like to discuss some of these behavioral conditions so that you can recognize them when they appear in your own thinking and act appropriately. Hopefully, this will allow you to make better decisions not only with money, but in all areas of life.

One of the most powerful behavioral finance concepts is that of loss aversion, which refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Studies suggest that losses are twice as psychologically powerful as gains (Tversky and Kahneman). Researchers have found that investors will take more risk to avoid a loss than to realize a gain. When faced with a sure gain most people are risk-averse, but when faced with a sure loss they become risk-takers. Consider the following problem:

1- You have been given a gift of $1,000. You are now asked to choose between:

A) A sure gain of $500

B) A 50% chance to gain $1,000 and a 50% chance to gain nothing.

2- You have been given a gift of $2,000. You are now asked to choose between:

A) A sure loss of $500.

B) A 50% chance to lose $1,000 and a 50% chance to lose nothing.

In the first situation, 84% chose A, and in the second 69% chose B. The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently. (Kahneman & Tversky, 1979)

Loss aversion and the fear of regret explain why people hold onto losing investment. They are anchored to the original or recent prince and can not bring themselves to sell as it declines because they are avoiding the pain and regret of having made a bad investment.

Some other interesting biases:

Bandwagon or herd effect- the tendency to do (or believe) things because many other people do (or believe) the same. Examples include similarity in analyst ratings, investor sentiment, etc. This leads to market bubbles and crashes.

Confirmation bias- the tendency to search for or interpret information in a way that confirms one's preconceptions.

Positive outcome bias (wishful thinking)- a tendency to be over-optimistic about the outcome of planned actions.

Overconfidence- the tendency to overestimate one's own abilities.

Gambler's fallacy- the tendency to assume that individual random events are influenced by previous random events. For example, you flipped a coin five times in a row. you came up with heads each time and so you deduce that chance of the next flip being tails is greater than being heads. In reality it is 50/50.

Recency effect- the tendency to weigh recent events more than earlier events. This helps to explain why people are now more bullish as the market goes up and bearish as it goes down (and tend to think it will continue that way).

Clustering illusion- the tendency to see patterns where there aren't any that actually exist.

Framing effect- drawing different conclusions based on how data is presented (e.g., 50% success rate vs. 50% failure rate).

Touchy-feely syndrome- the tendency for people to overvalue things they have selected personally.

People who are less fearful make better investors. This is true from a number of different angles. On one hand, those who understand the nature of risk and reward are not swayed by the ups and downs of the market are less fearful. They know that to earn a decent rate of return they must be exposed to and endure the downsides that will occur. The good news is that you do not have to be the best stock picker or market timer to succeed in investing. Instead, you need to be realistic, not controlled by emotions, and stick to a solid plan.