Have you ever bought an investment, only to see it slowly decline in value? Or do you currently own an asset worth half the price you paid for it? If you answered yes to either of these questions, don’t worry, you’re not alone. You see, our personal experiences, emotions, and attitudes impact our investment decisions much more than we realize. Our unwillingness to sell that losing stock is not because of flawed investment analysis, but rather as human beings, we have a difficult time separating our emotions from personal investment decisions. This is something economists call behavioral finance.
Sit in on almost any finance class, and you will surely learn about traditional finance theory. Traditional finance theory assumes that investors approach their investments in 3 ways, they: diversify assets; avoid risk; and make rational decisions. However, behavioral finance, which is the interaction between traditional financial theory and the emotional reactions to events, makes evident that investors (a) do not in reality diversity; (b) seek to avoid losses, not risk; and (c) are not rational decision makers. Let’s take a closer look at each characteristic.
The first assumption in traditional finance is that investors diversify by putting their assets among different investments such as international stocks, domestic stocks, and small-cap stocks. It also assumes that investors look at their total portfolio as a whole and not just the risk characteristics of each asset. Behavioral finance, on the other hand, shows us that just the opposite is true: investors segment their assets, and practice what is known as mental accounting whereby the investor organizes investments into different pools depending on their stated purpose, such as a vacation fund or a shopping fund. For example, mental accounting is when you view your tax refund as new found money, or if you spend your birthday or bonus cash on new shoes you wouldn’t have otherwise bought because you think of that money as independent from your budget. Most of us practice this flawed mental accounting without realizing it, but research has shown that individuals that practice mental accounting tend to have less diversified portfolios and are exposed to more risk because they fail to look at their entire portfolio. Behavioral finance also tells us that investors do not evaluate risk on a portfolio level, but on an individual asset level. For example, one might avoid investing in commodities because of their high volatility and perceived risk, but what they don’t realize is that when commodities are combined with a well diversified portfolio, they actually minimize portfolio risk and enhance returns.
The second theory in traditional finance assumes that investors avoid risk and select investments with low volatility. However, studies by psychologists Amos Tversky and Daniel Kahneman of Princeton University found that investors actually prefer to avoid losses, not necessarily risk. In their seminal research titled “Prospect Theory,” Tversky and Kahneman asked respondents to choose between two scenarios: (a) a sure gain of $500 or (b) a 50 percent chance to win $1,000 or nothing at all. They also asked respondents to choose between another set of scenarios: (a) a sure loss of a $500 or (b) a 50 percent chance to lose $1,000 or nothing at all. Respondents overwhelmingly chose the sure gain over the chance to win more, and the chance to lose more/break-even over the sure loss. The psychologists concluded that “investors prefer an uncertain loss to a certain loss, but prefer a certain gain to an uncertain gain.” These results show that investors prefer to avoid losses, rather than seek to avoid risk all together. When investors avoid loses instead of risk, they tend to have overly conservative portfolios because they avoid investments that they perceive to have high risk.
The third assumption in traditional finance is that we are all rational decision makers; we evaluate all the available facts in an unbiased manner, make our investment decisions, and are unaffected by our emotions. However, in the market downturn of 2008-2009 we saw that investors are not always rational, and that they exhibit cognitive errors that cause emotions to dictate their actions. Economist Richard Thaler from the University of Chicago has identified several behavioral biases that impact investment decisions. According to professor Thaler, individual investors are overconfident in their ability to analyze financial data. For example, Stan-Investor buys a stock for $50, but now it is only worth $25; Stan-Investor refuses to sell because he is still confident the true value is $50, and that everyone else is wrong. Professor Thaler states that investors exhibit frame dependence, in that our risk tolerance is dependent on the current circumstance. For example, if our stocks are going up and up (like during the dot-com era), we tend to increase our risk tolerance and take greater risks; but if our stocks are declining in value (like during 2008 – 2009), we reduce our risk tolerance and become more conservative.
The subject of behavioral finance is relatively new; in fact, there are only a handful of universities that actually teach it, yet its significance is more important now than ever before. The US financial landscape has changed dramatically in the last 20 years. The responsibility to save for one’s retirement has shifted from the employer or government to the individual through the use of accounts such as 401ks and IRAs. While company pensions and Social Security are a guaranteed form of retirement benefit, 401ks and IRAs are not, which means emotions (both positive and negative) will play a much greater role in investment decisions and whether you have enough money to retire. The best way to avoid letting your investments fall victim to emotions is to consult with a Fee-Only financial advisor who will make investment suggestions and decisions, based not on emotions and behavorial biases, but on what is in your financial best-interest.