Much of our current understanding of economic theory is based on the belief that investors always behave in a rational way, and that all of the relevant information about the economy, the stock market, and individual stocks is already reflected in the current price. This assumption is the crux of the efficient market hypothesis.
But, researchers questioning this assumption have uncovered evidence that rational behavior is not always as prevalent as we might believe. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision-making process. You’ll be surprised at what they have found.
In 2001 Dalbar, an independent research firm, released a study entitled “Quantitative Analysis of Investor Behavior”, which concluded that average investors fail to achieve market-index returns. It found that in the 17-year period to December 2000, the S&P 500 returned an average of 16.29% per year, while the typical equity investor achieved only 5.32% for the same period – an astonishing 9% difference! It also found that during the same period, the average fixed-income investor earned only a 6.08% return per year, while the long-term Government Bond Index gained 11.83%. Why does this happen? There are a myriad of possible explanations.
Fear of regret describes the emotional reaction people experience after realizing they’ve made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. So, they avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. We all hate to be wrong, don’t we? But this personal bias ends up costing us much more than it saves us, as a rule.
What investors should really ask themselves when considering selling a stock is, “If this security were already sold, would I invest in it again?” If the answer is “no”, it’s time to sell; otherwise, the result is regret of buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made – and a vicious cycle ensues where avoiding regret leads to more regret.
Myopic Loss Aversion
Prospect theory explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what’s already been lost.
This loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners: they may believe that today’s losers may soon outperform today’s winners. Investors often make the mistake of chasing market action by investing in stocks or funds which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than money flows out from funds that are underperforming.
Over-/Under-Reacting
Investors get optimistic when the market goes up, assuming it will continue indefinitely. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring, or placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events which results in prices falling too much on bad news and rising too much on good news.
At the peak of optimism, investor greed moves stocks beyond their intrinsic values. When did it become a rational decision to invest in stock with zero earnings and thus an infinite price-to-earnings ratio (think dotcom era, circa year 2000)?
Extreme cases of over- or under-reaction to market events may lead to market panics and crashes. The bottom line is this: the number 1 cause of investor under-performance is panic selling. Next time you find yourself worrying about a big market crash, stop and ask yourself if perhaps you might just be overreacting a little. Avoiding a panic sale can improve your overall performance by a mile.
Conclusion
Behavioral finance certainly reflects some of the attitudes embedded in the investment system. Behaviorists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities – not to mention opportunities to make money. That may be true for an instant, but consistently uncovering these inefficiencies is a challenge. Questions remain over whether these behavioral finance theories can be used to manage your money effectively and economically. In my coaching practice, I use two tools to overcome personal bias and irrational decision-making. The first is training in the use of critical thinking skills, which helps investors rise above their emotional reactions to market events. The second tool is a Personal Investment Policy Statement, which is a written framework that my clients use to capture all of the important rules, procedures, strategies, and checklists that the will use to keep their decisions grounded in rationality. The results from using this approach have been excellent. If you would like more information about one-to-one coaching, email me at info@zeninvestor.org