Emotions can lead to loss aversion or overconfidence in investing
Human psychology affects investment decision makingNovember 9th, 2017
Economist Richard Thaler was awarded the 2017 Nobel Prize in the field of economics for his contributions to behavioral economics.
According to the Nobel committee, Thaler has “incorporated psychologically realistic assumptions into analyses of economic decision-making.”
Asked to describe the takeaway from his research, Thaler told the academy and reporters: “The most important lesson is that economic agents are humans and that economic models have to incorporate that.”
In plain English, his work examines how human psychology affects economic and financial decision making, as well as trying to make economists understand that “economic agents (that’s us) are human.”
That’s somewhat in opposition to many theories, which suggest that, whether in finance or economics in general, we kind of assume that individuals should behave according to models that economists created. Obviously, to most of us, that’s not always going to be the case.
Inasmuch as humans are hardwired to be emotional first and logical second, both awareness of the effect of emotions on your portfolios and training on how to deal with them in stressful times need to be part of your investing approach.
Behavioral economics is a relatively new focus in economics. It says that financial advice is a combination of traditional finance, psychology, and neuroscience. Further, behavioral financial advice is about improving investors’ decision making under pressure.
It’s about learning to manage our emotions, whether they’re positive or negative. While that might seem simple in principle, in practice, it’s not easy for most.
Behavioral finance, in simple terms, is finance for normal people.
An ongoing challenge—as demonstrated annually in the DALBAR reports tracking investor fund flows—is that the data shows that over time, investment returns are better than investor returns.
Here’s what I mean. Between 1997 and 2016, the average annual return of the S&P 500 was 7.68 percent. The average performance of the middle-of-the-road stock fund investor was just 4.79 percent.
There have been years, in fact, that the average investor actually underperformed the rate of inflation, which means that these investors actually lost buying power.
During this same period, the rate of inflation was 2.13 percent. Comparing the rate of inflation to the average performance of an equity fund investor, which was 4.79 percent, makes that performance even more underwhelming.
DALBAR said this in its most recent report: “Investors lack the patience and long-term vision to stay invested in any one fund for much more than four years. Jumping into and out of investments every few years is not a prudent strategy because investors are simply unable to correctly time when to make such moves.”
While there are many articles and commentary pushing investors into buy-and-hold and passive-indexing strategies, the reality is that few will ever survive the downturns in order to see the long-term benefits.
Those actions and diminished results occur because our emotions, such as fear or greed or exuberance, can dominate our decision making. Whether it’s real estate, stocks, bonds, gold, or silver, it’s emotionally easy to buy high because of exuberance and sell low because of fear.
Emotions come from that ancient part of our brain responsible for survival called the amygdala, which is associated with emotions of fear and aggression.
The same impulses that are sent to the amygdala in the emotional center of the brain are also sent to the rational center—the cerebral or prefrontal cortex.
An impulse sent to the amygdala takes 12 milliseconds to arrive. However, it takes 40 milliseconds for the impulse to get to the cortex. Forty milliseconds is fast, but it is 3.5 times slower than the impulse that has gone to our amygdala. This is why we feel before we think.
Those emotions sacrifice accuracy for speed, which is great in the face of the saber-toothed tiger looking your way, but often wrong in our day-to-day decision making, especially regarding investing intended to be for a longer term.
Examples of emotions working to mess up our investing strategy include those times when the markets are going up and people start herding. They become overconfident when they see good returns, and they may make more extreme decisions.
On the other hand, when markets aren’t doing that well, things like loss-aversion kick in. Fear, anxiety, and all of those types of emotions kick in and individuals actually try to get out of the market.
Stocks have done better than Treasury bonds over time, Thaler and fellow behavioral economist Shlomo Benartzi argue, because investors hate losses more than they love gains, and they focus too much on the near-term even when it comes to long-term investment goals like retirement.
You have to understand that the market, economy, nor pundit comments are the real basis for your portfolio results. The dominant factor in your portfolio growth is your saving and investing behavior. How much you save and invest and how long you stay invested matters more than all other factors combined.
Saving and investing behavior accounts for 87 percent of your portfolio growth. The other 13 percent of portfolio growth is split between market timing, asset allocation, and investment selection.
While behavioral finance has earned its place in investing and asset management, we believe it operates best in conjunction with modern portfolio theory, not apart from it.
First, MPT creates a framework for objective decision making. MPT helps you evaluate the benefits of adding asset classes to an existing portfolio and how best to allocate among those asset classes. Again, any number of investing approaches are reasonable.
Think about the fact that, in our digital world, and from a rational economist perspective, more information should enable us to make better decisions. However, that usually backfires when it comes to investments, because more emotions can lead either to more loss aversion or to more overconfidence.
A primary job of a financial adviser is to help clients manage their emotions and their decision-making around their money.
People who learn to reflect on their values before making a decision of almost any kind, including a financial decision, make better decisions. Values reflection won’t make you smarter, but values reflection will help to make you more rational.
Helping our clients to manage their emotions, align their goals with their values, and manage stress will have a much more positive effect on their portfolios than attempting to help them outperform the market.
As Nick Murray, author of “Behavioral Investment Counseling” and expert on behavioral financial advice in financial services, says so well, “Outperformance is not a financial goal, and consistent outperformance is not possible.” He’s right twice.
Finally, from Mr. W. Buffett of Omaha, in a foreword to Benjamin Graham’s “The Intelligent Investor.” He said, “To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework.”
Michael Maehl is a financial adviser and Spokane-based senior vice president of Opus 111 Group LLC, a Seattle-based financial services company. He can be reached at 509.747.3323.