The Power of the Human Mind
Investors are often portrayed as rational thinkers who, driven by financial self-interest, consider all the information available to them before making a decision. But are they? Do they evaluate their options with clear-eyed objectivity and then make sensible financial choices? According to the relatively new field of behavioral finance, they do not. In fact, the way your brain works often plays a critical role in your investment decision-making.
A growing number of researchers have found that people’s idiosyncrasies and psychological biases can lead them to act in ways that don’t make financial sense. Investors would do well to keep these discoveries in mind as they make decisions, especially in today’s volatile investment environment.
The Psychology of Investing
Until recently, most financial models were based on the assumption that ordinary people made decisions about their investments the way a mathematician or economist would – logically and rationally. But in the late 1970s, psychologists Daniel Kahneman and Amos Tversky embarked on research that led to an entirely a new field of study called “behavioral finance.”
In 1979, they proposed “prospect theory,” which was based on research showing that human beings put “different weights on gains and losses and on different ranges of probability.”1 In other words, people tend to get more distressed by the prospect of a loss than happy about the possibility of an equivalent gain.
A contributing factor to this behavior may be “loss aversion.” Studies have shown that people are willing to take on additional risk simply to avoid losses. They are less inclined to take on the same risk for a potential gain. This tendency may be one reason why investors are twice as likely to sell a winner as they are a loser.2
Furthermore, investors don’t want to admit when they’ve lost money. “Regret theory” suggests that an individual may resist selling a losing investment simply to avoid feeling sad or anguished about the loss.
But what if an investment is successful? Enter “overconfidence.” When people have good results, they are liable to interpret it as skill. In reality, it may only be luck. Researchers found this to be true when they analyzed the sports phenomenon of “hot hands.” They studied basketball players who had made their last few shots to determine how likely it was that they would make their next one and found that success didn’t depend at all on the previous shots.3
Human beings also seem to put too much faith in recent experience, believing that they can extrapolate future events from current trends – a tendency called “anchoring.” When a stock price falls, for example, they tend believe the decline will continue and might therefore sell a position prematurely. As more and more people follow suit, this “herding” behavior has been known to result in panics and crashes. Conversely, overly enthusiastic buying may cause bubbles.
Gaining the Upper Hand
So what can investors do to mitigate the impact of their psychological biases on their long-term investment results? The first step is an investment plan. It can help you keep your head when all around you are losing theirs. Other strategies include:
- An asset allocation strategy based on your goals, time horizon and risk tolerance to keep you focused on what’s most important to you.
- Diversification to help minimize swings in the value of your portfolio, which may reduce the temptation to act out of fear or exhilaration.
- Dollar cost averaging, in which a designated amount of money is invested on a regular basis and according to a plan, can potentially remove emotion from investment decision-making. It’s up to you to decide if continuing in such a plan is right for you.
Human psychology may be powerful, but you can make wise investment decisions despite its influence. For an objective viewpoint, call your financial advisor and ask for assistance.
Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.
Investing in mutual funds involves risk. Principal value and investment return will fluctuate with market conditions and it is possible to lose money when investing in mutual funds.
1 “The Ultimate Investor: The People and Ideas that Make Modern Investment” by Dean LeBaron and Romesh Vaitilingam, 1999. (http://www.investorhome.com/psych.htm)
2 “Are Investors Reluctant to Realize Their Losses?” by Terrance Odean, The Journal of Finance, October 1998. (http://faculty.haas.berkeley.edu/odean/papers/disposition/disposit.pdf )
3 “Hot Hands Phenomenon: A Myth?” The New York Times, April 19, 1988.