When it comes to money and investing, we’re not always as rational as we think we are – which is why there’s a whole field of study that explains our sometimes-strange behaviour. Where do you, as an investor, fit in? Insight into the theory and findings of behavioural finance may help you answer this question.
In 2001 Dalbar, a financial-services research firm, released a study entitled “Quantitative Analysis of Investor Behaviour”, which concluded that average investors fail to achieve market-index returns. It found that in the 17-year period to December 2000, the S&P 500 returned an average of 16.29% per year, while the typical equity investor achieved only 5.32% for the same period – a startling 9% difference! It also found that during the same period, the average fixed-income investor earned only a 6.08% return per year, while the long-term Government Bond Index reaped 11.83%. Why does this happen? There are a myriad of possible explanations.
Fear of regret, or simply regret, theory deals with the emotional reaction people experience after realising they’ve made an error in judgement. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. So, they avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. We all hate to be wrong, don’t we? What investors should really ask themselves when contemplating selling a stock is, “What are the consequences of repeating the same purchase if this security were already liquidated and would I invest in it again”?
Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behaviour more than the events themselves. Say, for example, you aim to catch a show at the local theatre, and tickets are $20 each. When you get there you realise you’ve lost a $20 note. Do you buy a $20 ticket for the show anyway?
It doesn’t take a neurosurgeon to know that people prefer a sure investment return to an uncertain one – we want to get paid for taking on any extra risk. That’s pretty reasonable. Here’s the strange part. Prospect theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more stressed by prospective losses than they are happy from equal gains. An investment advisor won’t necessarily get flooded with calls from her client when she’s reported, say, a $500,000 gain in the client’s portfolio. But, you can bet that phone will ring when it posts a $500,000 loss!
In the absence of better or new information, investors often assume that the market price is the correct price. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities. In bull markets, investment decisions are often influenced by price anchors, prices deemed significant because of their closeness to recent prices. This makes the more distant returns of the past irrelevant in investors’ decisions.
Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring, or placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events which results in prices falling too much on bad news and rising too much on good news. At the peak of optimism, investor greed moves stocks beyond their intrinsic values.
People generally rate themselves as being above average in their abilities. They also overestimate the precision of their knowledge and their knowledge relative to others. Many investors believe they can consistently time the market. But in reality there’s an overwhelming amount of evidence that proves otherwise. Overconfidence results in excess trades, with trading costs denting profits.
Behavioural finance certainly reflects some of the attitudes embedded in the investment system. Behaviourists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities – not to mention opportunities to make money. That may be true for an instant, but consistently uncovering these inefficiencies is a challenge. Questions remain over whether these behavioural finance theories can be used to manage your money effectively and economically. That said, investors can be their own worst enemies. Trying to out-guess the market doesn’t pay off over the long term.