There are a variety of emotional traps into which investors tend to fall. Here’s how to combat those emotions and let logic rule.
The past couple of years have demonstrated that we can’t always count on the stock market to behave as we wish or expect. For most of us, the great recession was a setback. It has affected people’s retirement funds, company balance sheets, and created an overall weariness toward investing. It’s also caused considerable confusion; whatever we thought we knew about investing and finance seems to be up for debate.
Because of recent events with the stock market, people may be more likely to make decisions based on a combination of cognitive and emotional influences. This is problematic, since rational decision-making is the basis for sound investing. How can we combat our emotions and let logic rule? By understanding how our emotions factor into our investment decisions and abiding by a few best practices.
Modern Portfolio Theory
A majority of the principles used today for security valuation, asset allocation, portfolio optimization, and performance measurement are a result of Modern Portfolio Theory (MPT). What we know about MPT is that it relies on assumptions based on how investors are supposed to behave including the assumption of rational behavior. However, investors aren’t always rational. People don’t realize how much their moods and emotions affect the application of those principles.
Most of us are aware of the terms “cognitive” and “emotional.” However, most people polarize the two, putting cognitive (or rational thought) on one end of a scale and emotional on the other. You may have heard from a friend (or a well-intended spouse) to “stop being so emotional and to start being rational!” The truth is, cognition and emotion are two distinct constructs, meaning that individuals can be high on both, low on both, or any kind of combination in between. In other words, you can be bright and capable of experiencing emotions (and therefore being affected by them). A very common trap we see people fall into is assuming that their decisions don’t have an emotional component to them. Additionally, our cognitive side includes biases and shortcuts that only give us half-truths. Our behavior is affected by both our cognitions and our emotions.
How Does This Relate to Finance?
MPT assumes people behave based purely on their cognitive thoughts free from emotion and cognitive biases which, as discussed, is simply not the case.
“But I don’t let my emotions or cognitive shortcuts influence my decisions!” you might say.
Perhaps so, but you would be the exception, not the rule. The truly tricky part is that we don’t always know when our emotions are influencing our behavior. And we know even less when we’re taking cognitive short-cuts. There are quite a few psychological games we play with ourselves without ever even realizing it. One of the most common is insisting that our truth (or what we call our own rational thought) is purely cognitive, although it’s more realistically a mix of our own beliefs, mental gymnastics, and emotional makeup. For instance, Monty Hall, the old game show host from “Let’s Make a Deal,” was fully aware of the behavioral connection between people and money. He watched people making foolish choices over and over while they insisted they were right (the emotional response). In fact, when we’ve taught the following Monty Hall exercise to groups, we usually get a few, very intelligent, individuals stuck in their own way of thinking. Let’s try it now: There are three doors. One has a prize behind it. Pick a door, but don’t open it. Now out of the two other doors, I disclose to you that one definitely does not have the prize behind it. You have the options of staying with your door, or switching to the other remaining door. What would you do? The answer is to switch from your original door, and that about 66% of the time you will be correct. Many people cannot agree with this insisting that both doors have a 50% chance of having a prize behind it (rest assured, there is a lot of data and research proving this is false). The rational choice is to switch doors, but not everyone sees it this way.
This is a prime example of cognitive biases and emotions being mistaken for pure rational thought. There are many ways in which our psychology affects our financial decisions. Too much optimism leads investors to underestimate risk, and pessimism causes investors to overanalyze. We know that when people become overconfident it tends to result in more frequent trading, which increases trading and tax costs and has a negative impact on performance. Pessimism limits timeliness in making decisions, therefore running the risk of limiting alternatives.
Traps to Avoid
There are five common traps into which investors tend to fall:
- Rules of Thumb. Making financial decisions based on what’s easy or familiar. Trap: The tendency to invest in local stocks.
- Mental Accounting. Compartmentalizing money depending on where it comes from or how it is spent. Trap: Saving for a house at a rate of 5 percent while obtaining a car loan at 8 percent.
- Snakebite Effect. Becoming more risk averse due to past events. Trap: Overreliance on low-risk, low-return options.
- Get Evenitis. Prioritizing the minimization of a loss. Trap: Refusal to sell a falling stock in the hopes it will turn around.
- Anchoring. Sticking to a reference point, such as the original purchase price of an item. Trap: Reluctance to continue to buy stocks that have increased their share price.
Understanding your risk tolerance and having a well-outlined investment policy helps avoid behavioral mistakes in financial decision-making. It’s best to make decisions with your financial advisor that clearly define long-term goals and outcomes and specify investment strategies that align with personal risk tolerance. Deviating from this plan and strategy is likely to be based on emotional influences. Additionally, inquire about the process your investment advisor follows so that there’s discipline behind the investment plans put in place. After all, a plan isn’t worth having if it isn’t followed and revisited regularly.