CHICAGO — In all of the animal kingdom, only we humans have the ability to employ reasoning in a way that allows us to reach rational decisions. Why is it, then, that we seem to misuse that ability so often, especially in important areas such as money matters?
In coining the phrase “irrational exuberance” more than 15 years ago, former Federal Reserve Board Chairman Alan Greenspan was thought to be warning us that the stock market was irrationally overvalued. As it turns out, his comment may have presaged a new field of study called behavioral economics—a new science that makes an effort to determine why supposedly rational humans make so many irrational decisions.
When it comes to how we handle our money, there’s no shortage of irrational decisions. Consider the person who drives five miles to save three cents per gallon of gasoline, or the investor who consistently buys stocks at their highs and then panics when the market goes down and sells them at their lows.
Certified Financial Planner Ben Sullivan of Palisades Hudson Financial Group, Scarsdale, N.Y., stresses that raw emotion can lead to incredibly poor money decisions. “One of the biggest risks to investors’ wealth is their own behavior,” he says. “Most people, including investment professionals, are prone to emotional and cognitive biases that lead to less-than-ideal financial decisions. By identifying subconscious biases and understanding how they can hurt a portfolio’s return, investors can develop long-term financial plans to help lessen their impact.”
Sullivan offers the most common and detrimental investor biases:
Overconfidence — “It’s easy to overestimate your own abilities in picking stocks while underestimating risks. Even professional money managers struggle to beat stock market indexes; the casual investor has even less chance,” he says.
“It’s almost impossible to hold a day job and moonlight as manager of your individual-stocks portfolio. Overconfidence frequently leaves investors with their eggs in far too few baskets, with those baskets dangerously close to one another.”
Loss Aversion — According to behavioral economics proponents, many people have such a strong fear of losing money that avoiding a loss gives them more comfort and pleasure than making a gain.
“Because of their loss aversion bias, some people will irrationally hold losing investments for longer than is financially advisable,” says Sullivan. “If an investor makes a speculative trade and it performs poorly, frequently he will continue to hold the investment even if new developments have made the company’s prospects yet more dismal. The inability to come to terms with an investment gone awry can lead investors to lose more money while hoping to recoup their original losses.”
Anchoring — Aversion to selling investments at a loss can also result from what economists call an anchoring bias. Some investors become “anchored” to the original purchase price of an investment. “If an investor paid $1 million for his home during the peak of the frothy market in early 2007, he may insist that what he paid is the home’s true value, despite comparable homes currently selling for $700,000,” says Sullivan. “This inability to adjust to the reality of market changes may disrupt the investor’s life should he need to sell the property, for example, to relocate for a better job.”
Following the Herd — Another common investor bias is following the herd. When the financial media and Main Street are bullish, many investors will happily put additional funds in stocks, regardless of how high prices soar, simply because “everyone else is doing it.” However, when stocks trend lower, many refuse to invest until the market shows signs of recovery. As a result, they fail to purchase stocks when they are at their most attractive levels.
Past Performance Bias — Despite frequent warnings from investment professionals that past performance is no guarantee of future results, many investors continue to use recent past performance as a guide to equity and mutual fund purchases.
Familiarity — Sullivan recalls a middle-aged banker who put more than half of his $500,000 portfolio in bank stocks. Another prospective client who’d sold his consumer-goods business to a big consumer-goods company then put almost all of his money—many millions—in that one company’s stock.
“Investing in what you “know best” can be a siren song leading investors astray from a prudently diversified portfolio,” says Sullivan. “That was the case with both of the investors mentioned above. One was familiar with banks; the other was familiar with consumer goods. Unwisely they both put all their eggs in a familiar basket.”
HOW TO COUNTERACT YOUR PERSONAL BIASES
Having a written plan is the key, Sullivan says. “Create a plan and stick to it. Hewing to a written long-term investment policy prevents you from making haphazard decisions about your portfolio during times of economic stress or euphoria. Selecting the appropriate asset allocation will help you weather turbulent markets.
“All investors should invest assets they may need to withdraw from their portfolios within five years in short-term liquid investments. Combining an appropriate asset with a short-term reserve gives investors more confidence to stick to their long-term plans,” he says.
If you can’t control your emotions—or don’t have the time or skill to manage your investments—consider hiring a fee-only financial adviser, Sullivan suggests. “An adviser can provide moral support and coaching, which will boost your confidence in your long-term plan and also prevent you from making a bad, emotionally driven decision.”
Sullivan feels that we all bring our natural biases into the investment process. “Though we cannot eliminate them entirely, we can learn to recognize them and respond in ways that help us avoid destructive and self-defeating behavior.”
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.