Going Against the Herd
Paige Lee | January 19, 2018
If you took Economics 101 in college, you would have heard your professor discussing how people are rational and efficient. This means that individuals are operating in a way that maximizes their benefits and minimizes their costs. It doesn’t take much observation to notice, however, that human beings often make decisions that can be incredibly irrational. This year’s Nobel Prize winner in economics, Richard Thaler, has been recognized for his work around this concept: investors are predictably irrational.
This is an area where financial advisors can provide immense benefit. By taking the emotionality out of investing, great advisors will help clients make rational decisions that benefit them over the long-term. Here are some of the major biases that impact investor behavior.
Human beings are wired to pay more attention to losses than gains. When your portfolio is up 20%, you are excited but probably don’t make any changes to your long-term plan. When your portfolio is down 20%, you may be calling your advisor in a panic, looking to move funds, and wondering how this will impact your ability to retire on time. This type of action, however, can be incredibly harmful to overall returns. Making changes when a portfolio is already down can result in an investor missing out on returns when a market starts to rebound. Long-term investors must be able to stomach both the sharp ups and downs in order to benefit from market returns.
It is easiest to remember things that have been most recently called into memory. What did you eat for breakfast this morning? What did you eat for breakfast 5 years ago?
Why is this important? Investors tend to focus on the markets’ most recent returns as an indicator of future returns. If the markets are doing well, it is easy to overweight these most recent years and believe returns will continue to go up. When markets crash, it is hard to regain faith in future returns. This can lead to herd mentality during bull and bear markets where investors pour more and more money into markets when returns are rising and pull money out when returns have fallen.
Could you make a confident prediction for what the stock market will return this year? Probably not. In fact, it may even be difficult to confidently predict whether the market will generally end up or down. When we look over the past year, however, investors may claim it was obvious that the stock market was going to have a great year. The past is always easier to predict given the information we have in the present. Our brain rationalize that an outcome was inevitable and we should have seen it coming and done something about it.
Avoiding Behavioral Mistakes:
Invest Systematically – Continuing to make regular contributions to your portfolio will ensure that you are purchasing securities at different prices and are less exposed to losses over one particular time period. By purchasing investments with the same dollar amount on a consistent basis, it means you will be purchasing more shares when the price is lower and less shares when the price is higher.
Understand Your Risk Tolerance – The importance of understanding risk capacity vs risk tolerance can never be underestimated. Risk capacity measures the amount of risk your portfolio can afford to take given your goals and time horizon. It is an objective measure of the amount of risk you should take to meet your financial goals. Risk tolerance is the amount of risk you can emotionally handle. It is a subjective measure of your attitude toward risk, indicating your willingness to accept potential investment loss in search of greater investment gain. A strong financial plan strives to align both capacity for risk with tolerance for risk. This will enable investors to reach their goals while being able to sleep soundly at night.
Hopefully, as you are reading through this article, you are able to identify some of your own biases when it comes to investing. Here at Avier, we understand that investing is a personal and emotional matter for our clients. We strive to unite the personal needs of our clients with the analytical aspects of investing to come up with a financial plan that is successful over the long-term.
In the words of Warren Buffet, “Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard.”