Modern portfolio theory is a generally accepted practice used by many financial advisors, individual investors, and large institutions in managing their investment portfolios. It aims to optimize the expected return based on a given amount of “risk”. Through diversification, the portfolio becomes more efficient at optimizing returns. This takes into account a plethora of mathematics and statistical analysis, involving standard deviation, correlation, and weighted averages. Regardless, the underlying idea is that modern portfolio theory helps investors systematically maximize their returns. Yet, this also assumes that investors are RATIONAL in their decision making. Academic research and historical analysis of investor returns reveal that to be far from the truth. This article will provide an introduction to behavioral finance and how we can use the knowledge to combat common investor biases in order to truly maximize returns!
What is Behavioral Finance?
Generally, behavioral finance refers to the study of principles of psychology that affect our behavior as investors. The underlying focus is investors are not always rational. Our behavior around investing, as with many other endeavors in life, are affected by our cognitive biases, behavioral habits, ability to have self-control, and a swath of other psychological tendencies.
For example, have you ever purchased an investment soon after reading an article, watching the news, or hearing from a friend how it’s gone up 100% or more over the past year? Think Bitcoin and other cryptocurrencies near the end of 2017. As crypto assets prices skyrocketed, there was an ensuing frenzy by “investors” to purchase Bitcoin. This was far from a rational investment, as crypto as it currently stands, generally relies on investments from a speculative standpoint. Meaning, there isn’t a fundamental way to value the investment as there is with stocks, bonds, or other publically available asset classes.
If purchased during the manic period near the end of 2017, investors who didn’t sell their holdings in crypto likely have experienced a major loss. They fell victim to a “herding mentality”, and were purchasing highly speculative investments at sky-high prices due to FOMO, or “fear of missing out”. In managing our personal finance and investments today, it’s become even more important to be aware of herding mentality as social media platforms such as Instagram, Twitter, Snapchat, and others amplify the effect.
Similar situations will present themselves, although potentially less drastic, throughout the lifetime of an investor. The key is to understand how behavioral finance principles can be used to combat your own cognitive biases or habits when it comes to investing in order to be successful long-term.
Biases That Impact Investment Performance
Behavioral finance has aimed to identify common biases that confront investors. As psychology blends with investment behaviors in behavioral finance, it makes sense these are likely ideas or biases that you’ve confronted in other areas of your life. The underlying idea though is to understand HOW they can impact investment behavior in order to avoid the pitfalls they tend to lead to.
Below, I’ve outlined 3 common biases to confront and avoid as investors.
Several prominent studies have been conducted that reveal how gains and losses affect investors emotionally. Through these studies, we’ve gained key insights into how losses, in particular, are roughly 2 to 2.5 times more painful to investors than an equivalent gain would be as joyful. Meaning, investors tend to focus more on avoiding losses than they do on making gains in their portfolio. Over time, if investors experience losses, they become even more prone to loss aversion.
This leads to investors holding unrealized losses (positions that have a loss but have not been sold in the portfolio) for longer than they should. Diving into the psyche of an investor experiencing loss aversion, they’re likely thinking “I’ll just hold on until it recovers, and then I can sell it for what I paid for”. Sure, it may sound logical at first glance, but in reality, the investor may be far better off selling the investment OR purchasing more shares at lower prices.
There isn’t a logical reason to hold an investment purely to recover the losses it’s sustained. If the fundamental reasons the investment was purchased remain intact, it shouldn’t change the investor’s long-term decision making. Likewise, if the fundamentals of the investment have changed, the investor should logically sell the position and move on. The decisions have to made through the lens of the entire investment portfolio, not just the singular position.
Key ways to combat loss aversion is to have a process in place. An annual rebalancing of an investment portfolio can systematically take out the emotions that play into loss aversion. It forces the investor to sell winning positions to buy more of losing position. As previously mentioned, if the fundamental asset allocation of a portfolio remains intact, this is a logical way to ensure the investor is selling at a high and buying at a low.
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Investing involves risk and over time risks can pay off. Sure, losses are sustained along the way, but historically the patient long-term investor has reaped the rewards. In making correct investment decisions, it can lead to an overconfidence in future decision making. Overconfidence can lead to several other types of biases that include an illusion of control, market timing, and the desirability effect.
First, when it comes to evaluating the markets on a day to day or even month to month basis, it’s impossible to predict which way prices will go. There are far too many variables to account for to lead to an accurate prediction of where markest will head in the short-term. Accepting that we have ZERO control over the markets in the short-term can help combat the illusion of control. Instead, focus on what we do control, our asset allocation, portfolio fees, and the ability to focus on the long-term.
Secondly, trying to time the markets also ties into the notion that we have zero control over the market in the short-term. We can’t accurately predict which way they’ll go. Therefore, we shouldn’t try to time when to make buy or sell decisions. Again, focusing on things we can control such as automated contributions to investments can help avoid market timing. Investors who try to time the market may find themselves sitting on the sidelines too long, waiting for the next recession or correction, only to miss out on valuable long-term gains.
Lastly, when we want something to succeed, we often succumb to “wishful thinking”. Purchasing individual stocks in which you’re emotionally tied to their success, whether that’s because of the investment itself of the company’s mission, can lead to investors holding onto an investment longer than they should. Wishful thinking isn’t logical, just because an investor wants something to occur doesn’t mean it’s more likely to. This is known as the desirability effect.
As previously mentioned, the idea that social influences and other investor decisions impact our own, regardless of any fundamental or logical decision making, is an example of herd mentality. It’s become even more prominent for investors in today’s world due to the immediate access of information on social media or news platforms. Marketers and more specifically Instagram influencers use this psychological tendency to influence buying decisions. A famous person wearing a new clothing line can influence their “followers” to purchase those clothes in order to feel in fashion or part of the lifestyle the influencer leads.
The same can be true in the investment world. During the dot com bubble of the late 90’s and early 2000s, investors poured into technology stocks. Many of which are now scoffed at in terms of their actual fundamental value in hindsight. Yet, people feared missing the returns that other investors were receiving at the time. This keeping up with the joneses mentality ultimately led to the tech bubble bursting, with only the companies that actually had fundamental value surviving.
View your investments through the lens of achieving your own goals. Don’t allow outside influences impact your asset allocation or investment decisions. Ultimately, if you’re able to achieve your financial goals, you’ll feel far greater happiness and success than if you succumb to a herding mentality and make decisions based on the crowd.
The Bottom Line
Understanding these basic principles of behavioral finance as it relates to portfolio performance can help investors be more successful long-term. Keeping our focus on things we can control such as developing a diversified asset allocation based upon your goals, automating contributions to your investments, rebalancing at a minimum annually, and keeping costs low, is key. And avoiding things we can’t control such as what the markets will do on a day to day basis and accepting the fact that we can’t accurately time the market. Putting a process in place helps to mitigate the outside influences presented by behavioral finance research and will help investors reap the rewards!
If you need assistance in developing a plan through the lens of your unique goals, schedule a free consultation today.