Understanding Behavioral Finance
By Sara Worley & Brendan Donahue
Investment Advisors, Manulife Wealth Inc.
According to a field of study known as Behavioral Finance, it is normal for people to make irrational decisions when investing their money. This makes sense, as investing can be an emotional endeavor. Here are some common behavioral biases people make, and ways to avoid them.
Overconfidence
Perhaps the most common behavioral finance concept, overconfidence occurs when people place too much confidence in their ability to predict the outcomes of their investment decisions.
While it’s important to invest confidently, applying too much can result in frequent and unprofitable trading habits or a portfolio that is overly concentrated in particular types of stocks, and thus susceptible to higher levels of volatility.
Loss Aversion
Tied to overconfidence, loss aversion is the reluctance to accept a loss, or the desire to book a positive return regardless of other factors. For example, a person experiencing loss aversion may decide to hold on to a losing investment because he or she hopes that it might one day recover, even if unrealistic. Or, one might decide to “double down” on a losing stock in the hope that the share price will at least partially recover.
In reality, the act of “doubling-down” can be akin to a gambling, for example, continuing to make large bets in the hope of breaking even. Sometimes, accepting a loss and moving on is the best course of action.
Frame Dependence
The tendency to change one’s risk tolerance based on the direction of the market has been a common phenomenon over the past several years. Low interest rates coupled with high returns in the stock markets have caused many conservative investors to take on more risk.
The problem is, while some people feel their risk tolerance rising along with the markets, they also feel their ability to tolerate risk falling with the markets. This makes investing an emotional activity, frequently resulting in buying high and selling low.
Though it can be hard to keep in mind, one’s risk tolerance should be based on their personal financial circumstances and investment time horizon, not the direction of the markets.
Representativeness
In behavioral finance, representativeness is most often defined as thinking that one thing means something else. This can take many forms but there are two facets which stand out.
The first is assuming that a stock must be a good investment because their company produces good products. Consider Crocs shoes, who went public in 2006 and quickly shot up to $75 per share, only to crash down to $1 less than a year later. In this case, owning shares of Crocs was decidedly less comfortable than wearing their shoes.
The second aspect involves placing too much focus on the past. This includes past performance, and the belief that one strategy or stock will always do well under all market conditions.
Many people currently hold this belief due to the superior performance of dividend-paying stocks of Canadian companies over the past 6 years. Many dividend-payers, however, are currently trading at unsustainable valuations, and may not be a good investment for new money.
Regret Minimization
Everybody wants to feel that they made a good decision. Some people struggle with feeling they, or their advisor, could have done better. Some people invest very conservatively, or avoid investing altogether, because they don’t want to feel the regret of an imperfect decision.
For example, a person sells a stock at a profit, but the shares keep going up. Many people would feel happy that they made a profit, but others would be unable to see past imperfect timing. It’s important to realise and accept that nobody is perfect and very few people are ever lucky enough to have timed the market perfectly.
On the whole, understanding how psychology plays a role in decision-making can help people and their advisors minimize investing errors and create better portfolios.