Behavioral Finance

Sounds exciting, doesn’t it? In fact, the more investors hear about this school of thought, the more they come to realize why they make the (sometimes frustrating) decisions they do where money is concerned. A brief history: most of the work in this field is credited to three academics, Amos Tversky (deceased), Daniel Kahneman, and Richard Thaler. The last two gentleman, who both worked with Tversky at times, were recognized for their work by the Nobel committee, Kahneman in ’02 and Thaler in ’17 (the prize is not awarded posthumously).

This can be a very wonky and technical subject but still highly relevant for retail investors. So let’s see if we can break it down into laymen’s terms and give some insight into how this affects us all on an almost daily basis.

If asked, most people would probably say they are rational individuals who make wise decisions. Indeed, logical thinking and prudent behavior are the norm for the majority of people in most instances. Unfortunately, when it comes to money management, people who are otherwise rational often tend to act irrationally, and this tendency is quite pervasive. Regardless of our age, level of education, or occupation, from time to time, many of us make illogical decisions when it comes to our finances.

For example, how many times have you heard of an investor (maybe it’s you!) who held onto a losing investment even when the prospects for recovery seemed slim at best? What about investors who sell their winning investments prematurely, only to see the value of the securities continue to rise? And why are some people more inclined to splurge with money that they may have received as a gift or inheritance while being more frugal with money that’s been earned? And what of those who succumb to the latest investment hype - all too eager to jump on the bandwagon of the current hot trend? Indeed, most of us recall the late 1990s and the growth of the dot.com bubble as more and more investors scrambled to participate in what was being called the “new economy.” Unfortunately, the bubble finally burst in 2000-2001 effectively erasing the wealth of many.

While conventional financial theory has long held that investors are logical individuals who seek to maximize investment returns through prudent and wise decision-making, in reality, research has found that investment decisions are often guided by emotion or intuition. This realization has led to the growth of Behavioral Finance: a field of study that seeks to explain the causes of irrational and often detrimental investment decision-making.

One of the key tenets of Behavioral Finance is that as humans, we are prone to biases or “mental shortcuts” that influence our decision-making. These biases often cause us to by-pass rational thinking and instead fall back on preconceived notions or intuition.

Loss Aversion

While there are numerous biases that influence how we behave, one that affects the logical decision-making of many is “loss-aversion.” Generally speaking, most people seem to have a natural tendency to despise and avoid losses. In fact, most tend to view losses more negatively than they will view positively a similar sized gain. As it pertains to investing, loss aversion may cause an investor to hold onto an underperforming security because if he or she were to sell it, the investor would have to face the reality of sustaining the loss and the potential anxiety that may ensue. On the flip side, loss aversion may explain why some investors may be quick to cash out of an investment that seems quite promising. To some, it may be better to lock in a gain of any amount than to suffer a potential loss in the future.

To avoid the pitfalls that may come from loss aversion, we believe that investors have the greatest chance for financial success when they remain unemotional with respect to their investments. Rather than reacting to short-term market events, we believe that investors are best served when they make strategic decisions that are consistent with their overall investment goals and objectives.

Mental Accounting

While loss aversion can help explain instances of poor decision-making, “mental accounting” helps to explain why some people illogically segregate their money based on its origin, or the anticipated use of the funds.

According to mental accounting theory, people often put more or less value on different pools of money based upon its source. Earned money, it seems, is valued more greatly than money that was “found,” as individuals seem to have a tendency to protect, and use more wisely, money that they’ve earned vs. money that was received otherwise. This may help to explain why a large percentage of lotto winners find themselves nearly broke after a few years. The same can be said for many young professional athletes in regards to a signing bonus. Logically, to maximize their overall financial well-being, most would be wise to treat all money as equal in value, regardless of its origin. After all, a dollar earned or a dollar gifted carries the same utility, while contributing equally to one’s bottom line.

Some other common biases…

Overconfidence – we are not as clever as we think and we therefore underestimate risk.

Attribution – our successes are due to our smarts and our failures result from circumstances beyond our control.

Hindsight – “I knew it all along.” Sometimes called Monday morning quarterbacking, you beat yourself up because you feel you should have seen it coming.

Representative – over-weighting the recent past in decision making. “This time it’s different…” Each market event is unique to its time and place, but that doesn’t mean you should stray from your strategy.

In Conclusion…

There’s little doubt that when it comes to their finances, people often allow their emotions, intuitions or biases to overrule logical thought. In doing so, they may be making decisions that on the surface seem “right,” but when examined more closely, are actually detrimental to their well-being.

The first step in avoiding the temptation to follow emotion is, perhaps, the recognition of such as a human tendency. If we can understand how and when we might be prone to act irrationally, we may be better equipped to avoid the temptation to act rashly, and instead, apply critical and reasoned thinking to our decisions, actions and behaviors. Consider a twist on an old adage, “Don’t just do something, stand there!”

Sources:

1. Shlomo Benartzi, Ph.D., Behavioral Finance in Action: Psychological challenges in the financial advisor/client relationship, and strategies to solve them, Allianz Global Investors, http://befi.allianzgi.com/en/Topics/Documents/behavioral-finance-in-action-white-paper.pdf

2. http://www.investopedia.com/university/behavioral_finance/behavioral2.asp