Psychology of Investing

During the last month, investors experienced unsettling volatility in the financial markets.  The onset of a correction coupled with constant media coverage is difficult even for the most experienced and sophisticated investors to navigate. To put things in perspective, it is important to clarify the difference between a bear market and a correction in a bull market. A bear market is usually defined as a market decrease of 20% or more. A correction in a bull market typically lasts three weeks to three months and is characterized by a decline of 5% to 15% from the market’s high. These corrections and bear markets can occur due to a combination of fundamental and psychological factors.

Investors who keep a longer-term perspective and employ patience during a correction generally fare better than investors who yield to emotion and keep a shorter-term perspective. We believe that practicing smart diversification, avoiding market timing, managing emotions, looking beyond headlines and focusing on what you can control are all imperative actions that sophisticated investors and experienced advisors can employ in investing. By understanding the field of behavioral finance – which combines behavioral and cognitive psychological theory and explains how investors make irrational financial decisions based on behavioral biases – investors can become more informed in their decision making process. Behavioral finance is a fairly innovative topic, popularized since the early 1990’s by Amos Tversky and Daniel Kahneman, winners of the 2002 Nobel Prize in Economic Sciences. Psychology plays a large part in investing and understanding psychological motivations can help investors avoid financial biases.

But why exactly does a laissez-faire mentality, specifically during periods of market corrections or volatility, work more efficiently than tinkering, constant headline reading and chasing returns?

Consider for example the month of March 2009, when investor uncertainty was at an all time high. Various media headlines swirled, stating that the market had and had not bottomed out. In hindsight, we know that this month was in fact the trough of the bear market and that significant gains were made since then. The exhibit below shows the cumulative performance of the major indices from the beginning to the end of the bear market and then in the subsequent recovery period. Though declines are difficult to stomach, investors who remained invested in the market during the crash had significantly better returns than investors that went to cash.

[fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”]

2008 Graphic
Source: Parker, Jim. The Certainty Principle. Dimensional Fund Advisors. www.mydimensional.com

Nassim Taleb, the author of The Black Swan, contends that under the narrative fallacy and confirmation bias, the financial media and investors can construct flimsy and non-logical stories of causation about what is happening in the markets. For journalists and media, building tidy and cause and effect stories are a good way to increase readership and ratings, but it is a terrible way to approach investing.[/fusion_builder_column][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][1] Many investors fall prey to seeking selective information to support their pre-determined assumptions. They avoid critical opinions and reports, reading only those articles that put their point of view in a positive light.[2]

Similarly, most investors fear losses more than they enjoy profits – a concept know as myopic loss aversion. Overthinking losses (and profits) means that investors make decisions that they would not make over longer periods of time. The more investors fixate on the daily swings in the financial markets, the more risky it will appear and the more likely it will lead to costly mistakes. If you could see the value of your home every second of the day, it would feel equally volatile and unnerving. Owning equity interests in large multinational companies is not just paper, it is real value which will be correctly reflected in the value of our ownership over time. Not checking performance too often, keeping a long-term perspective, and working with an advisor can help investors avoid the myopic loss aversion trap.

By nature, people are adaptive learners – we keep doing what has worked well and avoid repeating actions that have not worked well. This is not a good idea with investments, as it causes pro-cyclical behavior. If we apply human behavior in a natural setting to the financial market, we usually buy when it is too late and do not sell early enough.[3] In addition, investors can form unhealthy, emotional attachments to their investments. Behavioral economists call this the “sunk cost fallacy” where investors stick with a losing strategy simply because they have put time and energy into it.

Emotion Graphic

A consequence of the emotional roller coaster ride of irrational decisions is that investors rarely beat the returns on a diversified index. According to a 2011 Dalbar study, investor performance is 4.3% worse than an index. Investors do not realize that they are investing more poorly than the market is and succumb to various psychological pitfalls and biases.[1] We believe that a smart approach to investing involves accepting market prices and working with the market. Building a diversified portfolio around an investor’s risk appetite and goals and not media headlines is prudent.  Staying disciplined within your agreed upon asset allocation and regular rebalancing is crucial.

A financial plan, diversification, patience and knowledge are the most successful ways to build wealth over time. While we believe it is impossible to predict the short term direction of the financial markets, it is important to ground ourselves in the history of volatility so that we make rational decisions which leads to long-term success.  Focusing less on the day-to-day or short-term movements and more on how wealth accumulates through time is beneficial for investors.

We believe that even experienced investors should engage an advisor who understands their risk tolerance and long-term goals. The role of an advisor is to listen and acknowledge fears and keep investors on track to reach the agreed upon plan, especially in periods of corrections and market declines, when emotion can cloud judgement. Being aware of the behavioral finance discipline can help investors overcome biases, maintain an objective and non-emotional viewpoint and help clients maintain a disciplined, diversified and long-term portfolio.

[1] https://www.credit-suisse.com/media/pb/docs/us/privatebanking/services/cs_wp_behavioralfinance_final.pdf

[1] Parker, Jim. Connecting the Dots. Dimensional Fund Advisors. www.mydimensional.com

[2] https://www.credit-suisse.com/media/pb/docs/us/privatebanking/services/cs_wp_behavioralfinance_final.pdf

[3] https://www.credit-suisse.com/media/pb/docs/us/privatebanking/services/cs_wp_behavioralfinance_final.pdf[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]

Recommended Posts