As published in the Shore 2015 Edition of NJ Lifestyle
Traditional finance has long held to the notion that investors are rational, unbiased, and risk averse. It also professes that investors’ comfort level for risk is essentially stable and individuals will only accept higher levels of risk if offered adequate returns. Many of us have learned from real world experience that this is not always true. To explain the realities of investing a new field of study has emerged, behavioral finance. The new discipline portrays investors as being regularly overconfident, chronically emotional, and habitually biased.
There are many psychological propensities leading to investment missteps identified in the behavioral finance literature. This article discusses three axioms that can be used to illustrate how psychological factors can cause investors’ mistakes that lead to market inefficiencies. By understanding the tendencies and biases of human nature, we will be better able to avoid them and generate better investment results.
Humility is Good, Overconfidence is Bad
Two financial economists, Brad Barber and Terrance Odean, have authored numerous articles describing the negative impact of overconfidence and self-attribution with regard to security analysis and investment returns. Investor success nurtures overconfidence and overconfidence can lead to poor trading decisions such as excessive trading, underestimating risk, overestimating returns, inadequate diversification, undue risk taking, and generally weak returns. The researchers examined the activity of a very large sample of accounts at a national discount brokerage firm. They reported that single men traded much more than married men and men in general traded significantly more than both single and married women. The researchers found that accounts with higher portfolio turnover generated significantly lower returns. Overconfidence is also amplified as investors acquire more information and as they moved from trading by phone to online trading. Self-attribution – defined as the characteristic of blaming others when something bad occurs and/or attributing a negative outcome to non-controllable factors – is closely related to overconfidence. Taking personal credit for favorable results is another characteristic of self-attribution. Investors need to understand the relationship between overconfidence, increased knowledge, method of trading, and investment activity. Optimistic investors were found to be less analytical; while pessimistic investors were found to be more critical. Learning to control overconfidence and learning to be more self-aware can improve your investment performance.
Seek Regret, Avoid Pride
Numerous studies of market transactions show that investors prefer to sell their winners rather than their losers. This is called the disposition effect. Human nature avoids regret, the emotional pain of realizing a mistake was made. People take actions to trigger pride, the emotional satisfaction that a decision turned out well. Not only do investors sell winners over losers, but the studies have also proved that investors tend to sell their winners prematurely. An article by Strahilevitz, Odean, and Barber concluded that investors are less likely to repurchase a security sold at a loss or repurchase a stock sold prematurely for a gain. They concluded that investors are more likely to later reacquire a security if it was sold at the right time for a profit. People like to relive good events and avoid the negative memories. Seeking pride and avoiding regret hinders the accumulation of investor wealth.
Emotions Can be Hazardous to Your Wealth
When developing an investment policy statement, planners determine a client’s risk tolerance based upon facts and circumstances. A client’s attitude to risk is a key input in determining proper asset allocation, but data indicates that an individual’s aversion to risk is not constant and is greatly influenced by emotions and feelings. According to Thaler and Johnson, investors are willing to accept more risk after earning gains (house money effect) and less risk after realizing losses (snakebite effect). Covel & Shumway concluded that losers accept higher levels of risk to breakeven (breakeven effect). Behavioral biases can be extremely costly during market volatility. Recognizing psychological biases can help clients avoid mistakes, maintain risk tolerance consistency, and improve investment results. Portfolios generally perform much better with a steady asset allocation versus one that adjusts based on emotions.
A basic principle in management is that planning should precede every activity. A well-developed strategic investment plan is the best defense against the psychological weaknesses. We need to strive to be open-minded and humble, avoid the illusion of knowledge, resist the hesitation of selling losing investments, control emotional reactions, and avoid following the crowd. We need to review investment performance at regular time periods, rebalance portfolios periodically, and reduce turnover. Understanding the concepts of behavioral finance can assist us to improve performance.
Author: Francis C. Thomas CPA, PFS
Tom Reynolds, CPA & Matt Reynolds CPA, CFP®
(Co-Managing Partners, CRA Financial)
Robert T. Martin, CFA, CFP®
(This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.)