Emotions and Investing
September 16, 2009
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To be a successful investor requires not only a plan, but the discipline to follow it. There are many pitfalls and stumbling blocks on the journey to “investments success” including our own brains, which, unfortunately, occasionally play tricks on us. Our decisions may cause results that are ultimately contrary to our own best interests.
In a previous post, When Our Brains Short-Circuit, I wrote how our brain can affect our long-term investing performance, because we can be afraid of the wrong things. There is actually much more to be said on the the discipline known as Behavioral Finance. And given the extremely difficult year we (investors and advisors, both) have all suffered through, now would be a good time to reassess our actual risk tolerance and try to understand how our emotions affect our investment results.
For an excellent summary of the practical implications of Behavioral Finance, I recommend a video presentation by Scott Bosworth of Dimensional Fund Advisors. His 20 minute talk, with slides, is called Behavioral Biases and Investment Implications. It combines theory, research and experience, but rest assured it’s not so technical that you’ll need a PhD to sit through it.
Bosworth discusses common biases, how they affect decision-making, and how investor behavior impacts investment results.
Here is my take on his presentation.
Overconfidence and Extrapolation
Overconfidence and over-optimism can cause investors to make irrational investment decisions; for example they may buy stocks that have gone up in price, simply because they have gone up in price. And many people believe they are smart enough to forecast the future, even though the future is unpredictable.
Hindsight Bias
Selective recall leads us to believe that past events should have been easy to predict. Consequently, we believe that future events should also be easy to predict. They are not.
Fear and Panic
When stock prices go down, investors feel the pain and fear more is on the way. The media feed on this fear. They are interested only in getting more advertisers, not your investment success. TV pundits, with their incessant and contradictory predictions, only serve to confuse you further.
After a steep decline, many investors just want to unload their stocks – they’ll sell at any price. The problem is that this common behavior merely locks in losses.
Moreover, getting out of the market can create more stress (not less) in your life, because at some point you have to decide when to go back into the market. Just when is that? After you are no longer afraid? After the market has gone up by 20%, 30% or more? After you’ve missed the rebound entirely?
Conclusion
The natural inclination of investors is to buy high and sell low. That is more than unfortunate. It is also why the research shows that investors typically under-perform the stock market, all of the time. Buy-and-hold investors, on the other hand, typically earn higher returns than those investors who try to time the market.
Unless you have a trusted advisor with a strong long-term philosophy, you may not survive the stock market’s turmoil. And make no mistake, the emotional responses of investors is a challenge that financial advisors have had to confront this last year.
Educating clients, instilling discipline and maintaining the right strategy are what good advisors provide.
Sometime during my third decade of being a currency trader psycho babble became a popular topic. That is my non derogatory term for the psychological probing of why traders act the way they do.
Among the conclusions were that traders are skeptical of something that is too good to be true (proven false in the last 5 years I suspect) and that fear of loss and greed in winning were the two main driving forces. Those two go hand and hand and are hardly news.
However the remedy to overcome the fear of loss was thought to be developing a good system of trading utilizing risk management techniques and doing your homework. The theory behind the latter of course is that the more you research something the more comfortable you will be with your decision. Research could include technical and fundamental analysis.
When you apply that to many of today’s investors it becomes fairly clear that the research is missing. They tend to buy off of a magazine recommendation, and that is why they often do not trust their selections; they have little knowledge of who is running their investment.
An interesting study would be to see the average holding period of an index fund versus an actively managed one. I suspect that index funds have a longer hold period.