Understanding the pitfalls of
behavioral finance in investing
Published on Friday, July 10, 2009
David Fay
The severe downturn of the financial markets that began in 2007 has led many investors to question the investment strategies and choices they made in the past. Investment decisions are among the most important life choices a person can make. They can determine where your children will be able to go to college, when you’ll be able to retire and the type of lifestyle you’ll enjoy after you retire.
As investors re-evaluate their strategies, reassess their tolerance for risk, revisit their asset allocation strategy and rethink their long-term financial plans, it’s important to be aware of psychological blind spots. These can lead to making persistently poor financial choices — errors that over time can do significant damage to our portfolios.
Traditional financial theory assumes all investment decisions are made rationally, based on the best available information. In theory, the result is an efficient market — one in which prices accurately reflect fundamentals, such as earnings and interest rates.
However, it’s not always easy to reconcile financial theory with financial reality. Investors can be determined to ignore the fundamentals, both in bidding stock prices up and creating “bubbles” only to watch them fall — and dramatically so as we have witnessed.
“In many important ways, real financial markets do not resemble the ones we would imagine if we only read finance textbooks,” notes Richard Thaler, a professor at the University of Chicago and a leading behavioral finance researcher.
It’s not that investors are totally irrational, Thaler argues, but rather that their thinking can be influenced by mental biases. These quirks can lead them to make choices that appear intuitively correct, but produce poor performance.
This is known as behavioral finance and it tries to find explanations for these apparent contradictions. It’s not that investors are irrational, but that their thinking may often be guided — or misguided — by subtle biases and mental blind spots.
Some examples include:
• Overconfidence. Investors generally assume they know more than they actually do. They also tend to remember previous investment decisions in ways that exaggerate their own foresight. This can lead to overly aggressive trading and a reluctance to admit — and correct — mistakes.
• Mental accounting. Financial experts often advise investors to take their entire portfolio into account when making investment decisions. Yet, some investors unconsciously divide their wealth into separate pots. If they have a big gain, for example, they may think of it as essentially “free” money and take greater risks with it than they would with their “own” money.
• Anchoring. Logically, investors should always base their decisions on current prices and expectations. Instead, they might become fixed on something such as they price paid for a particularly, which can then lead to refusing to sell at a price lower than — even when it makes more sense to accept the loss and invest their remaining money elsewhere.
• Framing. How people view a decision often depends on how their choices are presented. For example, there was a study that asked participants how much they would be willing to pay to avoid a one-in-a-thousand chance of being killed. On average, the answer was $1,000. Participants were then asked how much they would demand to accept the same risk. This time, answers ranged as high as $200,000. From an economic point of view, the two questions were identical, but subjects saw them very differently.
• Loss aversion. In a completely rational market, the risk of loss and the possibility of gain should carry equal weight. But, on average, investors place twice as much importance on avoiding a loss as they do on making a gain. In other words, to accept a 50 percent chance of losing $100, most people will demand at least a 50 percent chance of earning $200.
Are investors doomed to repeat these mistakes? Maybe not. Some studies have shown the more investors know about the investment process, the less likely they are to be misled by behavioral biases.
This is one reason investors are encouraged to develop prudent, long-term investment strategies that take into account their goals and tolerance for risk. While this doesn’t guarantee investment success, it can at least reduce the risk of being led astray by behavioral blind spots. That’s something even the smartest investor may benefit from in today’s volatile market environment.
Contact W. David Fay, second vice president of wealth management with Morgan Stanley Smith Barney, at ww.fa.smithbarney.com/davidfay or (502) 745-7069. His office is at 5255 E. Williams Circle.
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