In today's challenging market environment, learning the lessons of behavioral finance could significantly maximize the value of your investments.
This article is published with permission from InvestmentU.com.
Anyone who has studied finance has heard of something called the Efficient Market Hypothesis (EMH). Simply stated, this model is underpinned by 2 ideas. First, it assumes investors make rational decisions to maximize their wealth. Second, it assumes all available information is incorporated into the price of a stock.
In an efficient market the stock price reflects the stock’s inherent value. As a consequence, investors won’t be able to systematically beat the market over the long term.
But we all know from personal observation that investors don’t always base decisions on reasoned analysis, or act in ways that will maximize the value of their investments. And no matter what the EMH tells us, there are legions of investors—professional and individual—who believe they have the insight necessary to achieve above-market returns.
Experience shows the market is far from efficient; one factor necessary for complete efficiency would be the complete absence of human emotion in investment decision-making.
The field of behavioral finance integrates classic economic and financial theories with psychology and research into the investment decision-making process. This research is significant in that it identifies some of the ways that we, as investors, tend to fool ourselves. Even professional investors have to remain vigilant to avoid making the mistakes that can arise from human nature.
Pain versus pleasure
One type of common, non-wealth-maximizing behavior runs counter to the notion people make decisions based on maximizing utility. Research has shown that people place different weights on gains and losses.
For example, investors typically consider the loss of one dollar is twice as painful as the gain of one dollar is pleasurable. Losses have a much greater emotional impact.
Research also finds that people will take more risk to avoid losses than to realize gains. So rather than risk-averse, behavioral finance posits that investors are loss-averse and when faced with certain loss become risk-takers. This behavior is influenced by fear of regret.
In the real world of investing, this means investors often hold on to poorly performing stocks for too long and sell appreciating stocks too soon.
Boost net worth with total returns
Mental accounting is another type of behavior that can prevent investors from maximizing value. Individuals often divide different expenditures and investments into separate accounts rather than looking at their financial picture as a whole. Such behavior can have positive and negative consequences.
On the positive side, earmarking funds for specific goals can encourage saving. But such mental accounting can have a detrimental impact if an investor divides income and capital appreciation (the components of total return) into separate streams. Investors frequently avoid dipping into capital appreciation while considering income fair game.
An investor who focuses too narrowly on income generation could see the original investment decline in value if the security is generating a negative return.
To make sure that overall net worth moves in a positive direction, investors should focus on total return.
Don’t overestimate your abilities
Overconfidence is one of the most common biases that can impact both professional and individual investors. Research has shown people have a tendency to grossly overestimate their own skills and abilities. This tendency is observed in the context of investment management in several ways.
The overconfident investor tends to trade more frequently, on average, and excessive trading can have a very negative impact on investment performance as transaction costs mount even as the effort is only infrequently rewarded.
Overconfidence also goes hand in glove with loss aversion, with investors tending to sell stocks that have performed well while holding onto those that have performed poorly. They sell the stars in their portfolios with the expectation they will not only realize gains, but make new investments that will perform as well if not better.
Sadly, research shows, on average, the stocks investors buy underperform the securities they sell.
Don’t wait for an unlikely outcome
Another dangerous bias is called anchoring, which can make investors unwilling to sell a stock that has declined in value.
Using the purchase point as the anchor point, they will wait for a poorly performing stock to break even before they sell. This behavior can be very costly, particularly in a taxable account in which realized losses can be used to offset realized gains. Instead of waiting to break even, an investor who has taken the lessons of behavioral finance to heart should ask himself whether he would buy the stock again at the current price.
If the answer is no, it’s time to sell.
While reading psychological research on investor behavior might not be everyone’s cup of tea, the benefits from learning the lessons of behavioral finance could be significant. In today’s challenging market environment, it makes sense to go the extra mile to learn how to maximize the value of your investments.
The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.