Behavioral finance is a relatively new field of study that blends economics with psychology by studying the decision making process. It is becoming increasingly evident that much of human nature is contrary to successful investing and that nearly all aspects of financial decision making are influenced by emotions and biases embedded in the human psyche. Since emotional and cognitive biases are important forces behind irrational decisions, a good understanding of these biases can help you become a better investor.
How Logical Are Your Decisions?
Suppose that you are given $20 to play a simple game that will last 20 rounds. When each round begins you must decide if you wish to invest $1 for that round. The outcome of your investment depends on a coin flip, where heads means you receive $2.50 and tails means that you lose your dollar.
From a purely logical standpoint this game is attractive because the expected value of each round is $1.25, which is more than the dollar that it costs to play the game. Thus, a truly rational player would play each and every one of the 20 rounds in order to achieve the best possible outcome.
A study conducted in 2005 presented this game to three different groups of people. The first group of people had a type of brain damage that prevented them from feeling fear. The second group of people did not have any brain damage, and the third group of participants had brain damage in parts of their brains that were not involved with processing emotions and fear.
The results were unusual, but not completely surprising. It turns out that the group with the inability to feel fear made the most logical decisions, choosing to participate in 84 percent of rounds. On the other hand, the group with no brain damage only invested in 58 percent of rounds, and the third group — with brain damage unrelated to processing emotions and fear — invested in 61 percent of rounds.
Bad Decisions Follow Losses
More interesting than the results themselves was the effect that a loss had on subsequent decisions. In principal, a loss should have no bearing on the outcome of the next coin toss, because a coin has no memory. The group of people with brain damage that prevented them from feeling fear behaved accordingly; they invested in 85 percent of the rounds that followed a loss, almost exactly the same percentage as their overall participation rate. While the first group’s decisions were not affected by the emotions involved with loss, the other two groups saw sharp declines in participation following losses and invested in less than 40 percent of the rounds that followed losses.
Since these results indicate that poor decisions are more frequent after a loss, it should not be a surprise that many investors do not remain invested after difficult bear market losses. Indeed, loss induced risk aversion causes many investors to stop investing after experiencing losses, even if markets recover and asset prices are favorable. This phenomenon helps explain why so many investors have trouble buying stocks at the bargain prices that typically follow a bear market.
Long Games Can Lead to Bad Decisions
Another interesting aspect to this study was revealed when the 20 rounds were broken down into four segments of five games. The group that could not feel fear invested in roughly the same percentage of rounds in all the segments. The other two groups, however, showed increasing risk aversion. Although they began investing in about 70 percent of rounds in the first segment, they invested in less than 50 percent of the rounds in the last segment. Longer games lead to a greater tendency for suboptimal decisions, and none of these “games” ran as long as your investment portfolio.1
This interesting experiment supports other studies which indicate that the possibility of loss is twice as powerful a motivator as the possibility of a gain of equal magnitude. This bias leads to the widely recognized “failure to invest” syndrome that causes many individual investors to drastically underperform market indexes because of money that is “parked” or “sidelined” in money market funds and certificates of deposit.
You do not have to fall victim to your mind’s biases, however, and the more familiar you are with them the easier it is to catch yourself. Remember that there is a natural tendency to let your fear of loss lead you to disregard bargains when it is contrary to your best interest. Even the best investors experience losses. What sets them apart, however, is their ability to pinpoint favorable risk/reward profiles during challenging times. In order to become a better investor, you need to stay focused on fundamentals and stop “knee jerk” emotional reactions from driving investment decisions that can be hazardous to your wealth.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles. David serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.
1 James Montier, The Little Book of Behavioral Investing (John Wiley & Sons, Ltd., 2010), 21-24