When it comes to money and investing, we're not always as rational as we think we are—which is why there's a whole field of study that explains our sometimes strange behavior. Where do you, as an investor, fit in?

Insight into the theory and findings of behavioral finance may help you answer this question.

Key Takeaways

  • Mainstream financial theory relies on the assumption that market participants are rational actors, who are self-interested utility maximizers who never make mistakes.
  • Behavioral finance has emerged to challenge the assumptions of rational actor theory as it applies to markets, investments, and other financial matters.
  • Behavioral finance draws heavily from cognitive psychology to understand investor behavior in the real world.

Questioning Rational Actor Theory

Standard economic theory is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process. This assumption, known as rational actor theory (RAT), is the crux of the efficient market hypothesis (EMH). According to RAT, individuals rely completely on rational calculations to make rational choices that result in outcomes aligned with their own best interests, or utility-maximization. RAT supposes that rational actors make these rational choices based on error-free calculations given full and complete information that is always available to them. Rational actors thus try to actively maximize their advantage in any situation and consistently try to minimize their losses in a self-interested manner.

Researchers, however, have been questioning the RAT assumptions and have uncovered evidence that rational behavior is, in fact, not nearly as prevalent as we might be led to believe by mainstream economics. Behavioral finance attempts to understand and explain how human emotions influence financial and investment decision-making processes. You may be surprised by what they have found thus far.

The Truth About Investor Behavior

In 2001, Dalbar, a financial-services research firm, released a study entitled "Quantitative Analysis of Investor Behavior," which concluded that average investors consistently fail to achieve returns that beat or even match the broader market indices. The study found that in the 17-year period to December 2000, the S&P 500 returned an average of 16.29% per year, while the typical equity investor achieved only 5.32% for the same period—a startling 9% difference! It also found that during the same period, the average fixed-income investor earned only a 6.08% return per year, while the long-term Government Bond Index reaped 11.83%. 

In a 2015 follow-up of the same publication, Dalbar again concluded that average investors fail to achieve market-index returns. It found that "the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%. The broader market return was more than double the average equity mutual fund investor’s return (13.69% vs. 5.50%)." Average fixed income mutual fund investors also consistently underperformed—returning 4.81% less than the benchmark bond market index.

Why does this happen? Behavioral finance provides some possible explanations.

Fear of Regret

Fear of regret, or simply regret theory, deals with the emotional reaction people experience after realizing they've made an error in judgment. Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. So, they avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. We all hate to be wrong, don't we?

What investors should really ask themselves when contemplating selling a stock is: "What are the consequences of repeating the same purchase if this security were already liquidated and would I invest in it again?" If the answer is "no," it's time to sell; otherwise, the result is regret in buying a losing stock and the regret of not selling when it became clear that a poor investment decision was made—and a vicious cycle ensues where avoiding regret leads to more regret.

Regret theory can also hold true for investors when they discover that a stock they had only considered buying has increased in value. Some investors avoid the possibility of feeling this regret by following the conventional wisdom and buying only stocks that everyone else is buying, rationalizing their decision with "everyone else is doing it."

Oddly enough, many people feel much less embarrassed about losing money on a popular stock that half the world owns than about losing money on an unknown or unpopular stock.

Mental Accounting Behaviors

Humans have a tendency to place particular events into mental compartments, and the difference between these compartments sometimes impacts our behavior more than the events themselves.

Say, for example, you aim to catch a show at the local theater and tickets are $20 each. When you get there, you realize you've lost a $20 bill. Do you buy a $20 ticket for the show anyway? Behavior finance has found that roughly 88% of people in this situation would do so. Now, let's say you paid for the $20 ticket in advance. When you arrive at the door, you realize your ticket is at home. Would you pay $20 to purchase another? Only 40% of respondents would buy another. Notice, however, that in both scenarios, you're out $40: different scenarios, the same amount of money, different mental compartments. Pretty silly, huh?

An investing example of mental accounting is best illustrated by the hesitation to sell an investment that once had monstrous gains and now has a modest gain. During an economic boom and bull market, people get accustomed to healthy, albeit paper, gains. When the market correction deflates investor's net worth, they're more hesitant to sell at the smaller profit margin. They create mental compartments for the gains they once had, causing them to wait for the return of that profitable period.

Prospect Theory and Loss-Aversion

It doesn't take a neurosurgeon to know that people prefer a sure investment return to an uncertain one—we want to get paid for taking on any extra risk. That's pretty reasonable. Here's the strange part. Prospect theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more stressed by prospective losses than they are happy from equal gains.

An investment advisor won't necessarily get flooded with calls from her client when she's reported, say, a $500,000 gain in the client's portfolio. But, you can bet that phone will ring when it posts a $500,000 loss! A loss always appears larger than a gain of equal size—when it goes deep into our pockets, the value of money changes.

Prospect theory also explains why investors hold onto losing stocks: people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back. Gamblers on a losing streak will behave in a similar fashion, doubling up bets in a bid to recoup what's already been lost. So, despite our rational desire to get a return for the risks we take, we tend to value something we own higher than the price we'd normally be prepared to pay for it.

The loss-aversion theory points to another reason why investors might choose to hold their losers and sell their winners: they may believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing market action by investing in stocks or funds which garner the most attention. Research shows that money flows into high-performance mutual funds more rapidly than money flows out from funds that are underperforming.

Anchoring Behaviors

In the absence of better or new information, investors often assume that the market price is the correct price. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities.

In bull markets, investment decisions are often influenced by price anchors, which are prices deemed significant because of their closeness to recent prices. This anchoring heuristic makes the more distant returns of the past irrelevant in investors' decisions.

Over- and Under-Reacting

Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns. A consequence of anchoring, or placing too much importance on recent events while ignoring historical data, is an over- or under-reaction to market events, which results in prices falling too much on bad news and rising too much on good news.

At the peak of optimism, investor greed moves stocks beyond their intrinsic values. When did it become a rational decision to invest in stock with zero earnings and thus an infinite price-to-earnings (P/E) ratio (think dotcom era, circa the year 2000)? Extreme cases of over- or under-reaction to market events may lead to market panics and crashes.

Investor Overconfidence

People generally rate themselves as being above average in their abilities. They also overestimate the precision and veracity of their knowledge -- as well as the perceived superiority of their own knowledge relative to others.

Many investors believe they can consistently time the market, but in reality, there's an overwhelming amount of evidence that proves otherwise. Overconfidence results in excess trades, with trading costs denting profits.

Social Factors

While much of behavioral economics to date has been driven by cognitive psychology, recent research from economic sociology indicates that there are also supra-individual forces at work that drive investor behavior. A recent study, for instance, found that individuals become far more conservative when making investment decisions on behalf of close others - with people taking around one-third less risk in a portfolio intended for a child than one allocated for one's own behalf. Moreover, investors became even more conservative with investments made in accounts that had culturally-salient labels such as "retirement" or "college savings."

Other research is now looking at how social relations and also larger structures like culture play on financial decisions. This shows that investor behavior is driven not only by psychology but also by social factors.

Is Irrational Behavior an Anomaly or the Norm?

As mentioned earlier, behavioral finance theories directly conflict with those of traditional finance. Each camp attempts to explain the behavior of investors and the implications of that behavior. So, who's right?

The theory that most overtly opposes behavioral finance is the efficient market hypothesis (EMH), associated with Eugene Fama (University of Chicago) & Ken French (MIT). Their theory that market prices efficiently incorporate all available information depends on the premise that investors are rational. EMH proponents argue that events like those dealt with in behavioral finance are just short-term anomalies or chance results and that over the long term, these anomalies disappear with a return to market efficiency.

Thus, there may not be enough evidence to suggest that market efficiency should be abandoned since empirical evidence shows that markets tend to correct themselves over the long term. In his book Against the Gods: The Remarkable Story of Risk (1996), Peter Bernstein makes a good point about what's at stake in the debate:

While it is important to understand that the market doesn't work the way classical models think—there is a lot of evidence of herding, the behavioral finance concept of investors irrationally following the same course of action—but I don't know what you can do with that information to manage money. I remain unconvinced anyone is consistently making money out of it.

Frequently Asked Questions

Do people behave like rational economic actors?

For the most part, no. Behavioral finance and investor psychology reveal that despite the assumption of rational actors in mainstream economic models, human beings systematically deviate from this assumed behavior.

Why do economic actors behave irrationally?

Several reasons have been proposed. Cognitive psychologists point to limitations in the human mind's ability to identify and process information. Psychology also recognizes the role of human emotion and subjective biases when making decisions. More recently, economic sociologists have identified social and cultural forces at work.

What does this mean for investors?

By acting more or less "irrationally", behavioral finance suggests that investors fall victim to a series of cognitive, emotional, and social forces that lead them to make sub-optimal decisions and undermine their performance in the markets and elsewhere. By knowing these limitations of human behavior and decision-making, people can make corrections or adjust for them. It also implies that markets are not as efficient as standard theory predicts, leaving room for savvy traders to take advantage of mispricings and earn a profit.

The Bottom Line

Behavioral finance certainly reflects some of the attitudes embedded in the investment system. Behaviorists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities—not to mention opportunities to make money. That may be true for an instant, but consistently uncovering these inefficiencies is a challenge. Questions remain over whether these behavioral finance theories can be used to manage your money effectively and economically.

That said, investors can be their own worst enemies. Trying to out-guess the market doesn't pay off over the long term. In fact, it often results in quirky, irrational behavior, not to mention a dent in your wealth. Implementing a strategy that is well thought out and sticking to it may help you avoid many of these common investing mistakes.