One on the foundations of Modern Investment Theory is the concept of the rational investor. This means that when making a decision to buy or sell an investment, we are like computers and act only on facts and data. As we all know, this is rarely the case. Emotions and feelings factor almost as much into every investing choice we make. But why is that?
A new financial concept that has taken hold in recent years is that of Behavioral Finance. This has been used to understand why returns for average investors are consistently lower than the market indices. If investors have all available information on an investment, shouldn’t they be able to obtain returns equal to the Major Indices?
The answer is no. Behavioral Finance, suggests that emotions creep in and turn the black and white facts into cloudy gray. So, what are some of the common investing emotional gray areas that we all get drawn into?
Fear of regret – When we purchase an investment that is now not performing well, we fear selling it and admitting that we made a mistake and taking the loss. Instead, we hold the investment hoping the price will rise even though the data is telling us otherwise. On the flip side, we can also have Investment FOMO when a stock has performed well buying in at ahigh point because we feel that since everyone else is buying in, we should to.
Mental Accounting – This is the situation when we put our investments into different categories based on factors that are solely based on our emotional attachment, or lack thereof, that causes us to ignore the fundamental information that we have on a stock. We might hold on to investments longer than we should because they were an inheritance. How can I sell Nana’s stock?
Prospect Theory and Loss-Aversion – This is the investment equivalent of doubling down in black-jack. We are hard-wired to avoid negative results that we take extra risk trying to recover what has been lost that we often compound the issue. Loss-Aversion also explains why we tend to buy into investments that have had a recent gain. Rationally, we know that the stock may not have much upside left but emotionally we believe that the investment is going up and will continue to.
Recency Bias – Putting too much emphasis on the most recent news/research to the exclusion of historical data. When the market is performing well, we assume that it will go on forever in an upward direction or in market downturns that it too will last forever. Ignoring history which tells us that the truth is somewhere in the middle. This can cause us to buy stocks at a higher price than they are worth or rush to sell solid investments because we feel that the market will never recover.
What does this all mean for the markets? Are they as efficient and Modern Portfolio Theory tells us or are they inefficient and subject to the whims of irrational investors as Behavioral Finance believes? As with most things the truth lies somewhere in the middle.
Investors can sometimes be their own worst enemies, but learning from past mistakes to be able to self-correct when we feel we are acting in an irrational way or seeking professional assistance to help create and maintain a financial plan can help to avoid making costly financial mistakes.
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