This is an interesting topic because the concept of efficient markets rests on the belief that investors behave rationally – buying when prices are low and selling when they are high. However, this practice goes against the grain of human behavior. Why? Because we are not machines; our behavior is typically based on our emotions and our response can vary depending on several factors such as market volatility, what’s going on in our personal lives, or even the mood we’re in that day.
Researchers studied how our cognitive biases, behavioral reactions, lack of self-control, and a bunch of other psychological tendencies impact not only our investment decisions, but the market as a whole. This area of study is called behavioral finance, and a branch of study has identified the following distinct areas of personal behavioral influence.
- Recency Bias:
Recency bias is when an investor places greater weight on their most recent experience rather than historical measures of past performance. For example, an investor may assume the current market price of a stock is an accurate measure of the company’s performance without taking into account any influence of market trends, economic events, or even news headlines. This may cause them to either sell when prices are low, or hold onto a security when its fundamentals have actually changed for the worse.1
Anchoring is when an investor is trying to avoid a loss by hanging onto a declining investment until it returns to the price at which it was purchased. He or she is “anchored” to that price. However, this emotional response could mean significant losses because it overshadows other factors, such as fundamental changes in the company that have led to the price drop.
- Investor Regret Theory:
We hate admitting we made an error in judgment and the feeling of regret that comes with having to change course. As a result, we often drag our feet to avoid facing the consequences. To put this into investment terms, when an investment declines, we may hesitate to sell to avoid feeling regret over a bad decision. Bear in mind, this is how gamblers can rack up extensive debt. Rather than walk away after a losing hand, they may double down on the next hand to try recouping what they already lost.2
- Loss Aversion:
The theory of loss aversion is based on the premise that the pain of losing money is more powerful than the pleasure of achieving gains. Aversion to loss can cause many investors to invest too conservatively for their goals to avoid short-term market fluctuations. This emotion-based decision can result in a portfolio not even keeping pace with inflation, let alone achieving long-term goals.
- Irrational Behavior:
When investors watch their portfolios too carefully, they tend to react more dramatically than if they check them only every so often. Irrational behavior occurs in a couple of different ways. First, if an investment is outperforming, the investor may get excited and decide to buy more of it. Unfortunately, that may lead to buying a stock at the height of its market price, which is often ill-advised. On the other side of the coin, when prices drop, investors may be so aggrieved that they sell quickly to avoid additional losses. In extreme cases, when irrational behavior affects a wide swath of investors, it can lead to a market bubble (artificially inflated stock prices) or panic selling and a subsequent market crash.
- Recency Bias:
It’s human nature to react to positive and negative things that happen, and we can’t always control the emotions we feel. However, it’s important to maintain control of our actions, regardless of the stimuli. Experts believe that recognizing our feelings and controlling our subsequent reactions can not only impact our own portfolios, but the performance of the broader market as well.
An important key to choosing investments is to first determine your goals. Few investors are simply looking to earn lots of money. They usually have objectives for how they intend to use the money they accumulate.
Asset allocation is often the tactic of determining how much money to allot to different asset classes (e.g., stocks, bonds, money market accounts). Each asset class is generally associated with a risk-and-reward timeframe for delivering best performance. You may also want to consider a diversified portfolio; it’s not likely that any one investment will tank your finances or create exorbitant wealth. Spreading out assets and maintaining that allocation over the long haul can help smooth out the dips of market fluctuations that tend to elicit emotional responses.
While efficient markets are designed to buy low and sell high, it’s impossible to consistently time the market to do this successfully. Trying to predict market directions frequently leads to irrational behavior, portfolio losses, and unnecessary stress. Working with an experienced financial advisor is an effective way to help mitigate emotion-driven market reactions.
Financial advisors make recommendations based on your stated goals and objectives, not “hot tips.” By working with an advisor to develop a long-term strategy, investors can avoid many of the potential mistakes that can occur in reaction to market swings. An advisor can address your concerns and help you maintain a consistent, long-term investment portfolio with techniques such as systematic investing, portfolio rebalancing, and tactical allocation adjustments.
If you have any questions or concerns about your retirement portfolio, give our office a call today at 801-465-6990.
- T. Rowe Price. July 11, 2019. “How Human Behavior Affects Investment Decisions.” https://www.troweprice.com/personal-investing/planning-and-research/t-rowe-price-insights/retirement-and-planning/personal-finance/how-human-behavior-affects-investment-decisions.htmlAccessed Oct. 15, 2019.
- Cathy Pareto. Investopedia. May 17, 2019. “Understanding Investor Behavior.” https://www.investopedia.com/articles/05/032905.asp Accessed Oct. 15, 2019.
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