How your behavior can affect your investment decisions
As human beings, we can often react to events or experiences in an instinctual rather than logical or practical way. It is in our very nature and can, in many cases, not be avoided. That being said, having awareness of our natural behaviors towards experiences can help protect us from the consequences of acting on our emotions. Behavioral Finance emerged I the 1970’s with research from Nobel Laureate Daniel Kahneman and it is a “relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economic theory in order to propose explanations as to why people might make irrational financial decisions.”[i] In this article we identify some common behavioral biases that many investors possess in the effort to bring awareness of how your perceptions can affect your investment choices.
We are prone to feel negative emotions more strongly and remember them more vividly than the positive emotions and experiences we have. It is probably a long-inherited defense mechanism to remind us to be cautious. After all, we weren’t always living in houses far away from the rest of the food chain. Caution was a survival skill, and, for our brains, it still is.[ii]
So, what does this mean for our investment behavior? If you experience a $2 gain on an investment and then experience a $1 loss on the same investment, the $1 loss will leave a more lasting impression than the $2 gain. This type of magnification of negative feelings can affect the way that people invest and, among other things, discourage them from taking the correct amount of risk required to satisfy their long-term goals.
The first word to come to mind when considering this particular behavioral tendency is Hubris. Hubris is the character flaw possessed by the most memorable characters of Greek tragedies that eventually led to their demise. It is defined as excessive pride or self-confidence and, if you’re familiar with Oedipus or Achilles, overconfidence is not a trait that bodes well for them.
In finance, overconfidence comes into play when an investor begins to think he or she can beat the market. Having too much confidence in your investment abilities can lead to poor choices, improper asset allocation and taking too much risk.
It seems odd that these two behavioral tendencies can exist simultaneously but, nevertheless they do. It is likely that they do not reveal themselves at the same time but rather, come in waves. Loss aversion is more likely to exist consistently and be a constant reminder to remain cautious, whereas overconfidence may come in spurts during times of rapid gains.
Call it what you want; “Keeping up with the Joneses”, “the grass is always greener”, “if she jumped off a bridge would you go too?” People look at what others are doing and think, “They must know something I don’t.” This is evident by the fact that people often take investment advice from their neighbor who is touting some hot stock, media pundits who push what’s “trending” or a stock “expert” with a widely listened to podcast.
Making the choice to follow what others are doing with the assumption that they have some insight that is making their decision more accurate can lead to investment outcomes that are not suitable for your personal and unique financial picture.
Heuristics are mental shortcuts that we use in order to make decisions quickly. In many cases they are extremely important. They allow us to think on our feet in scenarios where that type of decision making is required. Think, someone is injured, and you need to help them, or you are playing a sport. In those types of scenarios, it the use of heuristics that prevent us from deliberating for far longer than the situation can allow.
The representative heuristic is used to make an assumption or decision based on associated information that you already possess. Here is an example:
Laura loves listening to classical music, she attends the symphony several times each year, she has a collection of musical instruments. Is Laura a classical musician or an accountant? Given the information provided, your mind probably assumed that she was a musician even though the probability of her being an accountant with a deep appreciation for music is far greater.
In investing people can tend to make swift decisions based on the most current information that they have. So, if the market is fluctuating and an investor is given the choice to buy an equity that has drastically reduced in price or sell an equity that has lost some of its value, the representative heuristic would lead the investor to make the latter choice. As we all know, “buy low and sell high” is the foundation of sound investment strategy, therefore the representative heuristic has led our emotional investor down the wrong path.
Set Goals, Stick to the Plan, Accept Help
Kahneman’s investigations revealed, “repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.”[iii] When it comes to making financial decisions, planning for your family’s future, and saving for retirement It is important to make deliberate decisions that are based upon the effect they will have on your long-term goals.
It is easy to recognize irrational behaviors after the fact. It is much more difficult to recognize the emotions behind your behavior before making a decision. The duty of a financial advisor is to help you focus on future goals by helping you create a meaningful vision of your future, a sound strategic investment plan and then implement that plan with investment decisions based on unbiased facts and research. Often times, investors will exhibit one or more of the behavioral traits listed above and a financial advisor will need to weigh the effects of each behavior in order to make recommendations that will meet the investor’s emotional and financial needs
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[iii] Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (Hoboken, NJ: Wiley, 1998)