The Art of Behavioral Finance

By Mark Wendell

It is said that the X factor in economics is human behavior, which is why economics is said to be a social science. The study of investor behavior is referred to as behavioral finance, the combination of investments, economics and psychology, “a field of finance that proposes psychology-based theories to explain stock market anomalies…within behavioral finance, it is assumed that the information structure and characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.” (Source: Investopedia)

In a perfect world, investors would be cold calculating machines, making decisions with dry logic and obsessive numbers-only analysis, devoid of emotions. But because world events and economies are shaped by the behaviors of emotionally driven human beings, Wall Street is inherently unpredictable. Philip Tetlock, a psychologist at UC Berkeley, wrote that “the vast majority of predicting experts performed worse than random chance, that fancy degrees were mostly useless when it came to forecasting.” Especially among well known experts the main reason for their faulty predictions is overconfidence, a state of denial about being wrong. Tetlock refers to this effect as ‘confirmation bias’,which leads people to give disproportionate weight to evidence that matches their prejudices, and causes them to only seek information that confirms their beliefs. He says the experts he studied believed themselves to be "dispassionately analyzing the evidence when they were really indulging in selective ignorance as they explained away dissonant facts and contradictory data, and therefore, became prisoners of their preconceptions." Most individual investors also tend to be overconfident about the scope and accuracy of their knowledge to discern the realities of assessing the actual value of an investment.

Behavioral finance researchers have concluded that most people tend to be instinctively risk-averse. An example is in our likelihood to overly diversify our portfolios when a higher return might be earned on a narrower investment. The reason is that most people give more weight to the prospect of losing, than they give to prospect of gaining. We feel the intensity of the pain of loss and experience it as personal failure, remorse or regret, more acutely than we feel the intensity of the exhilaration of pleasure or pride of an equivalent gain. Ironically, people tend to be most risk-averse when they’re facing the prospect of a gain and most risk-seeking when they’re facing the prospect of a loss. This is demonstrated by the way people double-down in buying additional shares of a severely depreciated stock with self-deceiving hopes of making a fortune. People tend to overweigh the low probability of potential high returns in long odds gambles ‘investing’ in bankrupt companies, and when buying lottery tickets and penny stocks. Market fluctuations, according to the legend investor Benjamin Graham, are “a consequence of the ingrained tendency of most people to speculate or gamble … to give way to hope, fear and greed.”

People have a strong aversion to regret, and they regret action more than inaction, which explains why most investors sit passively on losing investments in the hope of an improbable turnaround, when taking the active step of selling would often be in their best interest. This concept, termed ‘prospect theory’ by two research psychologists, Amos Tversky and Daniel Kahneman, described it as ‘lose aversion’ and ‘inertia’. Selling a losing position or reallocating an underperforming portfolio triggers a feeling of regret over having made an unwise decision in the past, even though failure to take action in the present might result in even deeper regret in the future. Thanks to inertia, people stick to the status quo, which offers comfort in the thought we’ve suffered only "paper losses", whereas changing an investment may put an actual dollar value on a loss. If we decide not to act, we tell ourselves we’ll have nothing to regret, no painful emotions to face for the time being. Fear of regret inspires investors to make fool hearty investment decisions that conform with a preconceived personal ‘smart’ self-image or maybe drive a desire to live up to their friends’ expectations, and then with peer pressure, remain detached with ‘paper losses’ allowing the investments to disintegrate. There is a big difference between prudence in taking a corrective action and blind procrastination just to avoid regretful feelings.

Framing is one of the most widely mentioned concepts in behavioral finance. It is commonly used in the context of benchmarking or ‘framing’ an investor’s returns to fit one’s expectations, lifestyle and goals rather than merely aiming for the highest market returns. Specifically, we use valid and convenient par values, usually market indices and the media’s impressions of their results, as the frame of reference to measure the outcome from our investing. A better valid ‘frame’ of reference against which to measure success or failure might be using a desired personal future dollar value, a net worth goal, or an income goal as a target more appropriate than simply using a specific rate of return. This concept provides a human dimension for measuring the success of investment management, rather than focusing solely on generic market performance numbers, the most common measuring method. This subjective personal reference-point approach is typically difficult to articulate usually due to an investor’s inability to have realistic, consistent, or honest expectations for investment results. Some investor’s would rather frame their results generically and against an impersonal market benchmark rather than define investment results in terms of sensitive personal values and then not feel personal with the results. Often it is easier to blame Washington, an investment company, or the financial advisor for unsatisfying results.

Framing is one of the most widely mentioned concepts in behavioral finance. It is commonly used in the context of benchmarking or ‘framing’ an investor’s returns to fit one’s expectations, lifestyle and goals rather than merely aiming for the highest market returns. Specifically, we use valid and convenient par values, usually market indices and the media’s impressions of their results, as the frame of reference to measure the outcome from our investing. A better valid ‘frame’ of reference against which to measure success or failure might be using a desired personal future dollar value, a net worth goal, or an income goal as a target more appropriate than simply using a specific rate of return. This concept provides a human dimension for measuring the success of investment management, rather than focusing solely on generic market performance numbers, the most common measuring method. This subjective personal reference-point approach is typically difficult to articulate usually due to an investor’s inability to have realistic, consistent, or honest expectations for investment results. Some investor’s would rather frame their results generically and against an impersonal market benchmark rather than define investment results in terms of sensitive personal values and then not feel personal with the results. Often it is easier to blame Washington, an investment company, or the financial advisor for unsatisfying results.

Investors want to feel they’re making logical and prudent decisions regarding their investments, yet research in behavioral investing makes clear how often people act out behaviors that may actually be contrary to their best interests. Adopting a professionally designed, disciplined, and honest long-term investment strategy with the ongoing guidance of a professional advisor is the best defense against self-defeating irrational behaviors. Not only should a plan contain personal goal-referenced, outcome-based,risk-managed strategies, it should also be designed to minimize emotional behavioral triggers if the investor is to avoid serious financial mistakes. Remember, stuff will happen to us and to our self-imagined stroyline, and since we are our own biggest advocate and worst enemy, how we respond to stuff will influence our hopes, dreams, and investment schemes.