Most people think investing is a numbers game, but it has as much to do with people as it does with figures. In response to this fact, behavioral finance has emerged to analyze just how much people influence the malleable numbers that make up the market. Their discoveries have been quite enlightening. One common observation that behavioral finance has proved is that investors, even though they act with the best intentions, are often their own worst enemies. This article will look at some of the psychological mistakes that cost investors in the long run.
Tutorial: Behavioral Finance
Meet Behavioral Finance
If the market is efficient, why do bubbles happen? Why do mechanical investment strategies suddenly fail? Why do strategies like value averaging work in an efficient market? These are some of the questions that interest behavioral finance people. They have put forth a number of explanations that boil down to:
a) Although the market is usually efficient as it can be, investors' inability to see the future means it suffers periods of confusion, and
b) the human element of the market precludes a perfectly efficient market and exacerbates any surprises. How? Read on. (To learn more, see What Is Market Efficiency?)
Markets become volatile when investors pour in money based purely on a few figures from the financials and the analysts' predictions without knowing about the companies those numbers represent. This is called anchoring and it refers to focusing on one detail at the expense of all the others. Imagine betting on a boxing match and choosing the fighter purely by who has thrown the most punches in their last five fights. You may come out all right by picking the statistically busier fighter, but the fighter with the least punches may have won five by first-round knockouts. Clearly, any metric can become meaningless when it is taken out of context.
If you believe that it is all in the numbers, then you have to react quickly to any change in the numbers to protect your profits. Numbers-only investors are the most prone to panic selling. They tend to hedge their buys with stop-loss orders that other traders will try to trigger in order to profit from shorting a stock. This strategy, called gathering in the stops, can increase market volatility for a short period of time and give the traders who short the stock a profit. What this doesn't change is the actual company beneath the stock. Short-term volatility in the stock market shouldn't affect a corporation's business operations. For example, Nike (NYSE:NKE) doesn't stop making shoes when its stock dips.
Believing the Past Equals the Future
When investors start believing that the past equals the future, they are acting as if there is no uncertainty in the market. Unfortunately, uncertainty never vanishes.
There will always be ups and downs, overheated stocks, bubbles, mini-bubbles, industry wide losses, panic selling in Asia and other unexpected events in the market. Believing that the past predicts the future is a sign of overconfidence. When enough investors are overconfident, we have the conditions of Greenspan's famous, "irrational exuberance," where investor overconfidence pumps the market up to the point where a huge correction is inevitable. The investors who get hit the hardest, the ones who are still all in just before the correction, are the overconfident ones who are sure that the bull run will last forever. Trusting that a bull won't turn on you is a sure way to get yourself gored. (For more, see Market Problems? Blame Investors.)
Along the same vein as overconfidence is the self-serving bias. This is when investors are quick to take credit for portfolio gains, but just as quick to blame losses on outside factors like market forces or the Bank of China. Much like an athlete blaming the referee for a loss, self-serving bias helps investors avoid accountability. Although you might feel better by following this bias, you will be cheating yourself out of a valuable opportunity to improve your investing intelligence. If you've never made a mistake in the market, you'll have no reason to develop better investing skills and your returns will reflect it.
This 50-cent phrase is an observation about investors' perceptions of risk. Investors will limit their risk exposure if they think their portfolio/investing returns will be positive – essentially protecting the lead – but they will seek more and more risk if it looks like they are heading for a loss. Basically, investors avoid risk when their portfolios are performing well and could bear more, and they seek risk when their portfolios are floundering and don't need more exposure to possible losses. This is largely due to the mentality of winning it all back. Investors are willing to raise the stakes to "reclaim" capital, but not to create more capital. How long would a race car driver survive if he only used his brakes when he had the lead?
The Bottom Line
This is only small sample of a whole list that includes overreaction, under-reaction, conformation bias, gambler's fallacy, clustering illusion, positive outcome bias, and on and on. Although academics study these phenomena for their own sake, investors should also pay attention to behavioral finance. That way you can look in the mirror and ask yourself, "Am I doing that?" (To learn more about how investors can get in their own way when investing, check out This Is Your Brain On Stocks.)