Behavioral Finance and Its Impact on Investing
Starting my career in finance at the turn of the century, I have lived through some of the best and worst times in investing and witnessed the role emotions play in decision making. Investors have experienced several market crashes (dot-com bubble, financial crisis, COVID-19) as well as seeing the S&P 500 roughly triple in that time period. I’ve always been fascinated by the wild swings in emotion that investors had throughout that time and was drawn to research Behavioral Finance to help explain how human emotion affects decision making.
Behavioral Finance theory has been studied by academics for quite some time. In 2002, this research gained additional credibility as Princeton University psychologist Daniel Kanheman PhD, won the Nobel Prize for his work studying the types of decisions that humans make in times of stress. Kahneman and his partner Stanford psychologist Amos Tversky showed that investors often fail to make decisions that are in their best interest when they are deciding on complex or uncertain situations. They make these complex decisions using shortcuts or “rules of thumb” and often consider factors that economists wouldn’t take into consideration in their analysis such as recent event bias, investors’ aversion to loss and fairness.
Kahneman and Tversky were pioneers in Behavioral Finance, but many others contributed to the research of human decision making and uncovered other biases that investors exhibit on a consistent basis.
In this article, you will learn about the Behavioral Finance theory and three popular biases that are commonly exhibited today. These are:
- Herd Mentality
- Loss Aversion
- Confirmation Bias
Herd Mentality
Herd Mentality is a behavior where people act the same way or adopt similar behaviors as others around them. In practice, I know none of us would jump off the Empire State building just because our friends were doing it, but there are plenty of instances where herd mentality takes form in both our personal and financial lives. There is even now an acronym that explains this, FOMO – which is the Fear Of Missing Out. FOMO is a concern that one is missing out on experiences, information, events, or profitable investments that others are taking advantage of. This leads to the desire to stay as connected as possible to what others are doing, which is only exacerbated by social media.
One great historical example of FOMO was during the excitement at the onset of the internet. While it is amazing to think that I lived quite a bit of my life before the internet was actually invented, during the 1990s the internet brought a whole new way of doing things. Investors began seeing the massive potential and poured money into “dot-com” companies. Some of these companies ended up surviving but many turned out to be pure speculation and went bankrupt. The most recognized bust of the dot-com era was Pets.com which famously ran a Super Bowl ad of a sock puppet doing interviews on the street and also had a float in the Macys Day Parade in 1999. Upon going public in 2000, Pets.com rose to $14/share before the company failed to live up to the hype and went bust shortly after.
Much like Herd Mentality can lead to FOMO, it’s important to remember that the media is rewarded by grabbing the attention of the public. Nothing sells newspapers and TV ratings more than fear. Unfortunately for investors, programs like CNBC’s “Markets in Turmoil” are always aired after the fact. They report on the losses that occurred in the market and rarely provide a guide about how to think about forward looking returns. It’s beneficial to think about what you can control and focus on long-term investing as opposed to the day-to-day noise of the 24-hour news cycle.
In the past 30 corrections the average one-year forward return was +24.8% and two-year +37.4% following the correction. Although not every one and two-year return was positive, they did provide investors with gains roughly 90% of the subsequent rally.. See the chart below.
Loss Aversion
The concept of Loss Aversion was first identified by Behavioral Finance pioneers Amos Tversky and Daniel Khaneman. The theory behind loss aversion is the tendency for people to prefer avoiding losses versus acquiring equivalent gains. This principle has gained prominence within behavioral economics and some studies suggest that losses are twice as powerful, psychologically, as gains. Humans tend to believe that it is better to not lose $100, than to find $100. The emotional value attached to a loss prevents a person from making logical decisions.
Understanding Loss Aversion can help you when making investing decisions. Loss aversion typically shows up in investors’ unwillingness to concede a loss on a bad investment and they will instead hold onto losing investments too long. In behavioral finance this is called the sunk cost fallacy – the decision not to abandon the investment due to prior emotional and financial investments that are no longer relevant.
Source: Ycharts
One example that hits close to home for me has been the performance of General Electric, as many of my friends and family have worked there over the years. One common conversation that I have centers around whether they should sell GE stock or “wait for it to come back”? Therein lies the problem, the decision to sell or continue to hold the stock should have nothing to do with previous performance (except for tax considerations), and instead should be decided by their future outlook for that company.
To help protect against loss aversion it is important to have a long-term investment plan to help guide you. Having a plan in place with predetermined entry and exit points to help take the emotion out of the decision-making helps in making logical decisions.
Confirmation Bias
This is one of the behavioral biases that we are all prone to, that is seeking out information that already confirms our previous views. Instead of looking for viewpoints that may differ from what we already believe we look to those that agree with us, which could lead to overconfidence in our views. It also doesn’t give us the opportunity for someone else to challenge our view or potentially learn about information we hadn’t previously considered.
This happens more often than we realize. For example, on average when Republicans look for news they tune into Fox News, and when Democrats turn on the news, they watch MSNBC. Confirmation bias can be troublesome for investors as you don’t get the opportunity to see other points of view and in what scenarios you could be wrong. When managing investments, it is important to seek out the opposing view and try to analyze how they came to that conclusion. If you like a stock, find an investor who has a bearish view and try to better understand how they came to that conclusion. In doing so you typically find out new information that had not been considered, and at the very least get a well-rounded viewpoint.
In summary, Behavioral Finance plays a part in financial markets on a daily basis. By understanding behavioral biases, we are able to protect against actions that could be harmful to our investments. In most cases, having a long-term investment plan and tracking your progress versus that plan is the best way to protect from the day-to-day emotions of the markets. At Bouchey Financial Group, we would love to partner with you to help you achieve your financial goals. Contact us to set up a meeting today.
You might also be interested in:
- A Letter from our President & CEO: Ukraine People, War and Markets
- How Will Rising Interest Rates Affect Stocks?
- Planning for Retirement – 5 Factors to Consider Beyond Your Finances
Bouchey Financial Group is a fee-only, fiduciary, financial advisory firm with locations in Saratoga Springs & Troy, NY.