Behavioral Finance: Taming the Animal Spirits
Let’s say I offered you the following gamble:
We flip a coin.
Heads you win $110
Tails you lose $100
Would you take me up on it?
This type of question may offer some insight into your internal decision-making process about money. Assuming we’re not dealing with a fake coin, this bet mathematically has an expected payoff of $10 and you should take the bet. Most people wouldn’t though.
Since 2002, when a Nobel Prize was first awarded for research on the topic, I've lost track of how many presentations I've attended and expert papers I've read that share research on this growing topic. The question above is a simple example of the type of research being completed in this area, much of which supports and elaborates on the age-old wisdom about the role of fear and greed in the markets.
“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. ”
The Psychology of Losses and Gains
Specifically, questions like the one above illustrate the general tendency toward "loss aversion" and "narrow framing." Loss aversion is the idea that most people value gains and losses differently. In general, the absolute joy of winning $110 is felt less powerfully than the pain of losing $100. For most people, the pain of loss is more than two times more powerful than the joy of an equivalent dollar gain! Narrow framing is the tendency to view a question such as the one above in isolation and reject the gamble because it's viewed as too risky. However, if you were offered a chance like the one above every day of your life and you accepted, on average, you’d end up with $150,000 from your daily gambles.
“People rely on a limited number of heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations. In general, these heuristics are quite useful, but sometimes they lead to severe and systematic systematical errors.”
Discovering & Defining Financial Behavior
A few other interesting noted behaviors, or heuristics:
Mental Accounting: Placing a different psychological value on equivalent dollar amounts depending on the intended use of each dollar. For example, holding vacation savings in a piggy bank earning 0% return while carrying a credit card balance with a 15% rate. Or treating a tax refund or bonus as “found” money and spending more frivolously than other dollars.
Confirmation Bias: Finding sources of information that support a pre-conceived notion. Reading or listening exclusively to sources which support your political or economic views is a common example of confirmation bias.
“In the business world, the rearview world is always clearer than the windshield.”
Hindsight Bias: A situation where someone believes, after the fact, that an event was predictable and obvious. Classic examples are the tech bubble, the bear market of the early 2000s, and the 2008 global financial crises.
Anchoring: Mentally pegging a certain number without it necessarily having any justification. “My stock was at “X” at one point, so I’m sure it will come back.”
Media Response: The feeling of needing to “do something” in response to market news, when often no action and maintaining a long-term plan is often the best course.
Regret: People tend to regret errors of commission more than omission; that is, taking an action that turns out poorly haunts us more than not taking an action that could have provided equal or greater benefit.
Overconfidence: The vast majority of people think they are above-average drivers. They tend to attribute positive outcomes with skill and negative ones with bad luck. Skill and achievement in one field or endeavor tends to give one an unreasonable level of confidence in another.
This research led to a 2002 Nobel Prize in economics for its founders and has challenged the way traditional economic models are applied. Economists no longer assume that people are always purely rational and always able to determine which action is in their best interest, or that they will act on that knowledge. I think most of us would say that this is just common sense because we know emotions get in the way of life's big decisions, but now we have a Nobel Prize to back it up!
Recognize Your Financial Behaviors
These types of behaviors are important to keep in mind when the market is in uncertain times. It's easy to be a bold investor when the market keeps reaching new highs; however, when "flash crash," "credit crunch," "subprime debacle," "housing market meltdown," or "tech wreck" are all you hear on the nightly news or see in your daily newsfeed, don't make instinctive knee-jerk moves that could be irreversibly detrimental to your portfolio. Instead, work with the tools and resources you have to help your financial decision making and behaviors:
Know thyself. Ask yourself what might be influencing your thoughts and impulses? Why might these behaviors be considered wrong? Review the common behavioral finance heuristics.
Review strategy. Did your plans hinge on you moving in and out of the market to avoid downturns? I hope not. Did you plan on buying low and selling high, or did you originally think it would be a good idea to buy a stock that looks like it's at the top of a mountain? Your plans should have been constructed with the understanding that downturns are a normal part of the market's long-term uphill climb and buying when things are cheap usually works much better than chasing returns.
Get help. Talk with an experienced financial advisor you trust. Aside from the advisor's professional training and experience working with other portfolios in challenging conditions, having an outside and somewhat detached opinion can be very helpful to the success of your portfolio.
Don't Let Behavior Dictate Decisions
Totally removing emotion from your investment decisions in the midst of a market panic is much easier said than done. However, with an understanding of common behavioral finance biases, such as those mentioned above, working to self-identify, and having a pre-set investment plan of action can be very helpful in dealing with market mania!
For more information about how your behavior and mindset can have an effect on your financial decision-making process, check out one of my recent “Money Matters” radio spots where I discuss mental traps that cost people money.