Are you an Emotional Investor?
For most people, they are asked this question and say “No. I am pretty logical when it comes to money and investments.” However, if you really think about your money decisions on a day-today basis, are they truly logic based and unaffected by emotions? Likely not.
The study of Behavioral Finance emerged in 2002 with research done by Nobel Prize winning psychology professor, Daniel Kahneman. His investigation revealed “repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.”
If people are able to come to the conclusion that some of the financial decisions that they make aren’t necessarily in their own best interest, then working with an unbiased financial advisor can help balance logic with emotion to produce the potential for a more favorable outcome.
THERE IS TRUTH IN THEORY
Consider for a moment that you are the CEO of your own company. You would have learned the hard way that a good leader always works with a team of trusted advisors. The President of the U.S. works with a cabinet and a staff of trusted colleagues to make policy decisions. Shouldn’t potentially life changing choices about your own financial future deserve the same careful consideration and perspective?
Several theories combine into the study of Behavioral Finance, but the main points can be summed into seven areas of observation about how investors respond when faced with financial decisions.
Loss aversion – Investors are more prone to feelings of loss than to pleasure feelings of a gain. Roughly translated, the good feelings generated by a $2 gain on an investment are exceeded by the negative feelings prompted by a $1 loss on a similar investment.
Overconfidence – People are overconfident about their own abilities to make sound investment decisions, especially in the case of entrepreneurs because they are by their nature risk takers. This overconfidence spurs too little diversification in a portfolio, leaving the individual at greater risk should the investments perform badly. Men also tend to be more overconfident than women and prone to higher risk taking behavior.
Procrastination / Inaction – Optimism leads to the belief that no matter what our troubles are today, it will all work out in the end. This anchoring behavior pushes the individual into denial that a bad investing decision needs to be terminated. Investors avoid selling or rebalancing a portfolio after having made a bad investment decision due to embarrassment and fear of admitting that they were wrong. When looking at the future, it is always easier to hang on to a known assumption rather than make the clean break and move on.
Herd Mentality – People tend to give too much weight to what the other people are doing believing that they possess an ‘insight’ or additional knowledge that makes their decision more accurate and should therefore be followed. Behavioral finance experts also found that investors tend to place too much worth on judgments derived from a small sample or a single “expert” source.
Mental Accounting – Investors sometimes separate decisions that should, in principle, be combined. This concept, first named by Richard Thaler in 1980 , states that people tend to segment their money into separate accounts for different goals, when in fact the funds derive from the same source. The best way to avoid the impact of mental accounting is to concentrate on the total return of your portfolio and not fixate on what happens to a single stock or mutual fund (even if it is your favorite!).
Framing - How investors tend to look at a problem results in how they perceive, or frame, the issue mentally.
For instance, hospitals can either report ‘survival rates’ or ‘morbidity rates’ when reviewing successes or failures in a clinical trial. However you look at the numbers, they are still the same basic facts. The framing constitutes how optimistically or pessimistically the situation is viewed.
Recency –The tendency to overemphasize the importance of short term results versus the long term. This type of behavior can lead to knee-jerk reactions to market fluctuations and can damage long term portfolio results by making decisions based on short term, random information. Longer term data is generally more useful in investment decision-making since there is more information to interpret.
FOCUS ON YOUR 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 financial advisors 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.
With both personality and money profiling as part of a holistic financial planning program, a financial advisor should work to help each client to better understand the behaviors that can harm investment performance.
Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (Hoboken, NJ: Wiley, 1998)