Being Human Works Against Investor Success

Behavioral Finance

The academic field of Behavioral Finance has been developing over the past 25 years and it has identified biases and behaviors that often inhibit our success as investors. This academic discipline blends Psychology and Finance and it has demonstrated time and time again that when it comes to our personal finances, we are nothing like the perfectly rational decision makers imagined by classical economists.  Rather, we are very irrational and often let our biases as human beings influence our financial decision-making processes.  Thus, becoming aware of our natural biases can be a good first step in helping us avoid some financial mistakes.

One example is “loss aversion”.  In a nutshell, it has been observed that we experience roughly twice as much “psychological pain” when experiencing a financial loss when compared to the “psychological joy” we experience when receiving an equal financial gain. Said another way, losing 5% on an investment feels as bad to us as the equivalent happiness we receive from a 10% gain.  This asymmetry causes us to often take irrational actions (or inactions) to avoid experiencing losses.  A good example of loss aversion is the common investor behavior of hanging on to losing investments in the belief that “we must get back to break even”.  Doing so allows us to avoid the admission that we made a mistake but continuing to hold a loser may prevent us from taking advantage of better investment opportunities elsewhere.  Likewise, retaining the loss position in a taxable account prevents us from harvesting the potential  income tax benefits from a realized capital loss.

Yet another behavioral bias is “herding”.  The tendency to orient oneself towards the center of the herd is frequently observed in the animal world and we, as investors will often act similarly.  How else can one explain the periodic “bubbles” (e.g. the dot-com boom of 1998-2000) which can drive the prices of certain types of investments into the stratosphere?  Charles Mackey described this in his 1841 classic, “Extraordinary Popular Delusions and the Madness of Crowds”, yet even Mackey himself fell victim as an occasional booster of investment bubbles.

So how do we avoid being derailed by the simple fact that we are human beings?  Obviously, awareness can help and it’s been noted that there are at least ten major financial behavioral biases in addition to well over one hundred variations.  Relying on prudent processes such as structured asset allocation and formulaic rebalancing can take the emotional element out of many investing decisions. Finally, soliciting the opinions of others may help us to  “see things through a different lens” and may at least cause us to consider other factors that might come into play.