A growing field of study — behavioral finance — is focused on identifying the potential pitfalls of the human psyche to help investors minimize the effect emotions can have on their portfolios.
In an ideal world, every financial decision you make would be based on extensive research and thorough analysis. But let’s be honest. Purely objective assessments aren’t that common; emotions can, and do, routinely skew your perspective.
Consider your portfolio over the past few years. How many times have you called your financial advisor about a stock, bond or mutual fund based on a “feeling,” not fundamentals? When’s the last time a tip from a friend led you astray from your well-intentioned investment strategy?
To be fair, it’s nearly impossible to completely remove the emotional component from any investment decision. “As soon as money is committed to a financial asset, so, too, is an emotional stake,” says Marc Borghans, a senior portfolio manager for Northern Trust’s Wealth Advisory Services. “Recognizing that, investors will more likely avoid flawed decisions and achieve their financial goals when they become aware of their own behavioral biases and mistaken beliefs and work to overcome them as much as possible. In the process, a conscious effort to keep crowd emotion at bay may come in handy.”
Behavioral Finance: A Multifaceted Field
Studied within academia since the early 1970s, the field of behavioral finance has gained significant traction within the larger investment community over the past dozen or so years. The scope of the late-1990s technology bubble — and its sharp implosion — and the degree of the recent housing bubble, which nearly took down the world’s financial system as it collapsed in 2008, helped underscore the danger of rallies fueled by irrational behavior.
Philosophically, behavioral finance is considered a counterpoint to the efficient market hypothesis, which holds that all financial market participants are rational and a security’s price at any given time fully reflects all available information. Although such thinking dominated financial theory for decades, the booms and busts of recent years have prompted many to question its validity.
While presuming that even near-perfect information fails to explain day-to-day price moves in stocks, bonds and other investments, behavioral finance researchers have identified a number of behavioral patterns among investors. Some of the more prevalent ones include:
Exuberant Extrapolation: Because individuals want to believe in the durability of broad market trends, they tend to overemphasize recent experiences and extrapolate them into the future. Yet such focus can foster a herd mentality that funnels too much money toward stale trends and an increased likelihood of subpar returns in the future. “The optimism that prices will keep going up can lead to buying at the peak,” says Yale University Professor of Finance Nicholas C. Barberis.
Brazen Overconfidence: Very few people like to admit that they’re wrong. At the same time, many investors frequently shrug off new insights, believing in the superiority of their personal viewpoints. Barberis says such overconfidence frequently manifests itself in brokerage trading accounts, where research has shown that people who trade the most tend to be the worst performers. These investors would do much better if they cut way back on their trading, or didn’t trade at all.
Mistaking the Noise for the Signal: To deal with an information overload, people tend to revert to mental shortcuts in making judgments. While rules of thumb may be helpful in keeping perspective and instilling a sense of control, Borghans says, chances are that oversimplification, stereotyping and readily embracing information that confirms investors’ pre-existing beliefs and ignoring evidence that contradicts their views augment investment mistakes.
Putting Off Pain: No one enjoys getting hurt. In the investment arena, this frequently leads to a refusal to sell losing positions, because selling is seen as an acknowledgment of a poor investment decision, Barberis says. Instead, he adds, investors prefer to sell winners to lock in a positive return and generate a “nice” investment story that is fun to think about and share with others. Meanwhile, laggards are pushed to a corner of the portfolio, where they frequently continue to falter and weigh on true returns.
Steeling Yourself for Emotional Shortcomings — Conquering Your Emotions
Experts in behavioral finance are quick to acknowledge that conquering one’s emotions is far from easy. The first practical step to minimize the effect of emotions on our investment decisions is simply becoming aware of the mistakes that can result from internal biases, Barberis says. Once that awareness exists, investors can take a stab at exploring contrarian perspectives and challenging the reasoning behind any potential investment decision.
“If you’re about to buy a stock, force yourself to write down three reasons why it’s not a good idea to make that investment. If you’re about to sell, write down three reasons why you should keep the investment,” Barberis says. “Such an exercise forces you to look at the other side of the equation, and see why the opposite of what you’re thinking could be true.”
Frank discussions with your financial advisor are also valuable in keeping your finances on track. Indeed, part of Northern Trust’s wealth management philosophy is rooted in the desire to help shield clients from the effects of acting on their emotions, according to Borghans. Interestingly, to help accomplish this, Northern Trust borrows from another behavioral pattern — mental accounting, which describes people’s propensity to mentally categorize assets into noninterchangeable compartments relating to intended use or source of those funds.
More specifically, Northern Trust investment advisors aim at creating a dynamic wealth management plan around your personal life goals, which likely fall into the following categories:
- Aspirational goals, which may include starting or funding a new business or spending a year traveling around the world.
- Philanthropic goals, which may include supporting core causes or creating a family foundation.
- Legacy goals, which may include transferring wealth to another generation and educating your heirs about the responsibilities of wealth.
- Lifestyle goals, which may include maintaining your current lifestyle, making a major purchase or covering college education costs for your children or grandchildren.
“Importantly, identifying and understanding clients’ unique life goals and commitments ahead of time increases the likelihood of attaining them,” says Borghans. “With this in mind, categorizing and prioritizing goals and liabilities properly tends to illuminate clients’ ability to assume investment risk. Subsequently, in our portfolio structuring and investment strategy, we translate those life goals into a discrete set of distinct investment objectives, which may include capital preservation, cash-flow generation, market- based growth and opportunistic wealth creation. Finally, we select appropriate investment vehicles to match the objectives and do so in a tax-friendly way. Hence, the best practical asset mix follows logically from a goals-centered ‘bucket’ approach and is unique to each client situation.”
By changing the investment discussion from specific securities’ prospects to the merits of goals and objectives — whether short-, mid- or long-term — Northern Trust has found that investors are less likely to fixate on the market’s day-to-day noise, which can easily sway emotions. “If you know where you are going and recognize the investment path you are travelling while keeping return expectations realistic, you tend to enjoy a calmer, more disciplined state of mind. This, in turn, allows you to stay the course, no matter how the market winds are blowing,” Borghans says. “At the end of the day, it is our clients reaching their life goals that determines our investment success.”
Keeping Your Cool — Recognizing Market Irrationality
With hindsight, periods of excessive market irrationality are easy to spot. In the midst of the fever pitch, however, arguments on both sides of the debate tend to prove quite compelling.
“In 1999, all the talk was how the new technology of the Internet was truly transforming how business was done. In 2005 and 2006, as housing prices kept climbing, people argued that we were running out of land and home prices would always go up,” Barberis says. “Part of the problem with irrationality is that it is difficult to prove its existence with certainty.”
Every investor is prone to emotional swings — even experienced professional money managers occasionally succumb to an internal bias. But as behavioral finance pushes further into the mainstream, such patterns will likely become less of a mystery and more of a key element in savvy investors’ decision-making processes.