This month we have been discussing behavioral finance at Elevate, which is the study of how human psychology affects investment decisions. Behavioral finance may not have quite the rich history as the study of “rational” financial decisions, but it has nonetheless become a serious and well-supported academic discipline in top business schools across the country. The theory can be summarized in two broad statements:
- Human beings are not perfectly rational, have limited mental capacity, and suffer from a wide array of cognitive biases that serve as shortcuts when making decisions under uncertainty.
- These cognitive biases influence our monetary decisions, as well, often leading to suboptimal actions that can negatively impact the goal of wealth accumulation.
The science of behavioral finance began in 1979 with Prospect Theory by Daniel Kahneman and Amos Tversky, who discovered that given a certain amount of money, losses are felt roughly twice as intensely as gains are enjoyed. This discovery led to the realization that most people are risk averse in the domain of gains, but risk seeking when facing losses. For example, most people will choose to receive a certain $100 rather than accept a 50/50 chance of gaining $200. (The expected value of both options is identical.) But at the same time, they will take a 50/50 chance of losing nothing or $200, rather than accept a certain $100 loss. This explains why gamblers are more likely to take longshot bets at the horse track at the end of the day, when they have likely experienced some losses, in the hopes of getting back to even.
Today, it is widely accepted that human beings are not perfectly rational, and they do not always act in their own best interests. Because our mental capacity is limited, we have evolved many shortcuts, or “heuristics,” to help us make decisions under uncertainty, especially in stressful or complicated situations. While these shortcuts helped our ancestors survive to live another day, they probably did not prepare most of us to understand how markets work, or how to be patient, long-term, successful investors.
[Note that just because most individual investors may not be perfectly rational, this does not necessarily mean you can expect to find irrational prices in public markets. It would only take a relatively small number of rational actors to exploit any profit opportunities created by mispriced securities.]
For investors seeking to improve their investment returns, just being aware of these “cognitive biases” is half the battle. Knowing that they exist allows us to plan for them and hopefully minimize their impacts on our investment decisions. Behaviorist researchers have discovered dozens of these biases; below is a list of just a few of the most common:
- Mental accounting — although money is fungible, people tend to allocate money in their minds for specific purposes.
- Herd behavior — following the crowd, chasing popular stocks as they move higher, or selling them after they’ve experienced losses.
- Investing with our emotions – especially fear and greed, which often lead to poor timing decisions near market bottoms and tops.
- Anchoring bias – becoming fixated on a single data point, especially the first piece of data presented.
- Attribution bias – attributing success to one’s own behavior or decisions but blaming losses on outside forces or poor advice. This bias is also linked closely with overconfidence.
These cognitive biases and others can exert profound sway over investment decisions, often steering individuals away from rationality. Moreover, emotions wield considerable influence over investor behavior, shrouding judgments and affecting financial outcomes. Understanding the interplay between emotions and cognitive biases equips investors to navigate the financial landscape with better clarity. Incorporating emotional biases into the understanding of investor behavior also enables financial professionals to provide tailored guidance and strategies. By recognizing and managing these biases, investors can forge paths that are more aligned with their financial goals, thereby enhancing long-term financial success.
