Over the years I’ve come to appreciate the field of Behavioral Finance, which seeks to explain the difference between how people should make investment decisions (according to traditional investment theory) and how they make them in real life.
Behavioral Finance seeks to explain aspects of investor behavior not captured in more traditional economic approaches to investing. Behavioral economists believe that investors often don’t behave the way traditional economists think they should. Whereas the traditional economic approach assumes that investors are rational and incorporate all available information into their decision making, Behavioral Finance stipulates that investors are not always rational. People are “normal”, and normal people are sometimes irrational.
- They often act on biases and misperceptions.
- They don’t incorporate all relevant information into their decision-making.
- They sometimes base their investing decisions on emotions.
An investor’s cognitive and emotional biases can negatively affect their portfolio’s performance.
Let’s look at an example of irrational investor behavior from a Behavioral Finance perspective.
A client – we’ll call him “Harry” (not his real name) – held a sizable position in an individual stock of a publicly traded pharmaceutical company. When Harry first came to Sensible Financial, we recommended that he divest this holding immediately. It comprised a large proportion of his overall portfolio, adding significant risk. We explained the benefits of diversifying into low-cost mutual funds to reduce investment risk. We also learned that this company’s recent phase 3 clinical trial of a new drug failed, and its only other product offering was experiencing stiff competition. The company’s stock price had declined as a result. Harry agreed with our recommendation about diversifying but was reluctant to sell this holding just yet. He wanted to wait until the stock price increased again so that he could at least recoup the value of his original investment.
Two types of counter-productive behaviors at work here, according to research in Behavioral Finance, are Anchoring and The Disposition Effect.
Anchoring is the idea that once we decide, we remember our decision (however arbitrary), which becomes the starting point for the next decision. In the above example, Harry bought a stock and it lost money. He remembers clearly the price at which he purchased it. Despite evidence that the company is likely in for a rough ride, he is reluctant to sell the stock until its price recovers to his original purchase price. He thinks there is something intrinsically significant about that price. This is irrational behavior. The diversification issue notwithstanding, only the stock’s future prospects really matter, not what Harry paid for the stock. Harry should ask himself, “If I didn’t currently hold this position, given what I know today about the company’s future prospects, would I buy the stock today?” If the answer is no, he should sell it.
We can see anchoring in other areas besides the stock market. If you have ever haggled with a foreign merchant at one of those outdoor bazaars, you probably negotiated the price of a trinket downward once the merchant gave you his initial asking price. You “anchored” on his initial asking price. However, the asking price might have had nothing to do with the item’s intrinsic value. Instead, you should have done some research ahead of time on what that trinket is actually worth and then negotiate from that price point. Of course, this is more easily said than done. You would need to know what you were going to buy ahead of time. But you get the idea.
The Disposition Effect is the tendency to hang onto a losing investment too long, and to sell a winning investment prematurely. Despite the fancy name, this is really about loss aversion. Investors tend to feel twice as bad about a loss as they feel good about a gain of the same size. As a result, they end up holding onto (not “disposing” of) a losing position, hoping that it will regain its value. They also will tend to sell an appreciated security too soon, for fear it will soon lose value. That way, they don’t need to admit they were wrong about a losing investment, and they can take pride in the gains they made on one they recently sold.
Both of these cognitive biases are backward looking. Investors focus on what the investment was worth when purchased and compare that to what it is worth now. Instead, they should focus on what the investment is worth now compared to what it could possibly be worth in the future.
As for Harry, he finally decided to sell the stock, and he is very happy he did. The pharma company recently filed for bankruptcy.
Behavioral Finance identifies several other cognitive biases. I hope to provide additional examples of these in future articles.