Whether you’re a new investor or have several years of experience, understanding the basic concepts of behavioral finance can significantly benefit your ability to be a successful investor and help you avoid the biggest mistake most investors make.
What’s the biggest mistake investors make?
The inability to recognize one’s irrational investment behavior and thought process. This leads all too often to investors buying high and selling low. Even people who understand how behavioral responses can plague their investment strategy, have a challenging time overcoming the issue when it arises. This can lead to large losses and disrupt years of patient investing.
In simple terms, investors allow irrational thoughts to force their hand in buying and selling decisions.
The efficient market hypothesis states that all available information is reflected in prices in the market. However, through several studies, we know this isn’t necessarily true. During periods of extreme investor optimism (2000 tech bubble) and pessimism (2008 great recession), the intrinsic value of stock market prices and their companies are not accurately reflected. Intrinsic value simply includes all tangible and intangible (brand recognition) parts of a business in its valuation. We can attribute this to behavioral finance, a field of study that incorporates investors’ psychology into market price fluctuation.
During the 2000 tech bubble, investors flocked to the market, buying anything and everything they could relate to the internet. The internet surely was changing the world, and from the dot-com boom emerged several very successful companies. Unfortunately, there were also several that completely failed. This optimism helped form a large bubble in the technology sector. In contrast, in 2008, as our financial system began to collapse, investors panicked and sent the market into a free fall. During the tech bubble, optimistic investors were buying companies at huge premiums to their intrinsic value. In 2008, investors began selling companies for less than their values.
THIS IS IRRATIONAL THINKING.
A quick example of why this is irrational; through October 1st and October 10th, 2008, the S&P 500 dropped 22.11%. Investors panicked which resulted in a quick sell-off as they tried to protect against further losses. This was also the worst thing you could do. The best choice was the opposite, to add to your investments if possible. You’d simply be buying at a 22.11% discount. It’s irrational to think that on average a company in the S&P 500 lost 22.11% of its intrinsic value in 10 days. Sure, there were a plethora of problems at that time that was worrisome, but did we really think the American economy would falter for more than 3-4 years at most?
The savvy investor during these periods realized the emotional response moving the markets and bought during the downturn. Almost 10 years later, and the rebound from the financial crisis in 2008 has been nothing short of extraordinary. Resulting in one of the longest bull markets ever with a cumulative return of 249% as of March 9th, 2017. These opportunities come few and far between and it’s important you take advantage of them when you can rather than let them disrupt your long-term investment strategy.
How do you know when to sell?
We do believe it is harder to sell investments than to buy during each respective situation mentioned above. One great piece of advice we’ve heard from renowned CNBC contributor and CIO at Merrill Lynch, Mary Ann Bartels, is “that you know the market is acting irrationally when your UBER driver starts talking about buying stocks”. In other words, if the most casual of investors start talking about stocks to strangers, it could mean a sign of immense optimism in the market and, therefore, a potential opportunity to sell.
Obviously, all of this assumes that you aren’t needing the money within a short time frame. If you are, your asset allocation should be conservative to limit the volatility. This is a hard concept to master, as even the best money managers can fall prey to group thinking. However, understanding behavioral finance can give you a huge advantage as an investor during times of extreme optimism and pessimism by taking emotion out of the equation. It is inevitable each of these situations will arise again in the future, and remaining disciplined with a long-term strategy in place is key!