by Stephen W. Bedikian, Associate Wealth Advisor at Halbert Hargrove
The Impact of Behavior on Investment Decisions
Classical economics and investment theory are based on the fundamental assumption that investors make rational decisions. Unfortunately, human beings don’t always act this way. This is true for individuals managing their own personal investment portfolio; it can also apply to professionals investing large institutional portfolios. People often act irrationally due to cognitive biases, emotional factors, and social influences, which can lead to suboptimal financial outcomes – and huge regrets.
What is Behavioral Finance?
Behavioral finance is a field of study that combines psychology and economics to understand how individuals make financial decisions and how these decisions can deviate from traditional economic theories. Key theories within behavioral finance were developed by Nobel Prize-winner Daniel Kahneman and Amos Tversky in the 1970s.
Nobel Prize-winner Richard Thaler is also well-known for his work in the field. You may recognize him from his cameo appearance in the film The Big Short in which he and Selena Gomez use a gambling metaphor to explain synthetic collateralized debt obligations (CDOs).
Behavioral Finance Concepts
Kahneman’s Nobel Prize acknowledged his breakthrough work in recognizing that individuals value gains and losses asymmetrically. Prospect theory is based on studies that show that for people making decisions, losses typically have a greater psychological impact than gains of the same size. In general, investors experience losses about 2 to 2 1/2 more painfully as equivalent gains are pleasurable.
Loss aversion can compound negative performance experienced by investors. To avoid the emotional pain of loss, investors have a strong tendency to hang on to losing investments. In this case, their “patience” in holding onto a losing investment can be very expensive when the opportunity cost is added to the realized loss. The S&P 500 has gained more than 20% in each of the last two years – patient capital that sat in a losing investment during that period didn’t have the chance to participate in those large gains.
A core principle of behavioral finance is that individuals do not always act in their best financial interest. Psychological factors like overconfidence and herding behavior can also influence investment choices. For instance, overconfidence leads investors to overestimate their knowledge and abilities, which can cause them to take excessive risks. Meanwhile, herding behavior describes the tendency for individuals to mimic the actions of others, especially in times of uncertainty, even when those actions may not be in their best interest.
Mental accounting refers to the cognitive process where people categorize and treat money differently depending on its source or intended use. For example, individuals may treat a tax refund as “extra” money and spend it more freely than regular income.
How Cognitive Biases Shape Investment Choices
Behavioral finance also explores how biases like anchoring (relying too heavily on the first piece of information encountered) and framing (the way information is presented) can influence decisions. For example, an investor might make a purchase decision based on the price of a stock relative to its past price rather than its current value or future prospects, or they may react differently to a gain framed as a “win” versus a “loss.”
Other common behavioral finance biases include:
Confirmation Bias
Confirmation bias happens when investors have a bias toward accepting information that confirms their already-held beliefs in an investment. When this kind of information surfaces, investors accept it readily to confirm that they’re correct about their investment decision—even if the information is flawed.
Experiential Bias
An experiential bias occurs when investors’ memory of recent events unrealistically heightens their expectation that the event is far more likely to occur again. It’s also known as recency bias or availability bias.
For example, the financial crisis in 2008 and 2009 led many investors to exit the stock market. Many had a dismal view of the markets and likely expected more economic hardship in the coming years. The experience of having gone through such a negative event increased their tilted view of the probability that the event would reoccur. In reality, the economy recovered, and the market bounced back in the years that followed.
Familiarity Bias
The familiarity bias happens when investors tend to invest in what they know – domestic companies or locally owned investments, for example. Investors tend to go with investments that they have a history or familiarity with. This can result in a lack of diversification across multiple sectors and types of investments in their portfolio, which can increase risk.
Join our Webinar on Behavioral Finance on March 6
In practice, behavioral finance has important implications for both individual investors and market outcomes. Investors who understand their own biases can make more informed decisions, while financial advisors and institutions can use this knowledge to better design investment strategies and products that try to account for irrational behaviors. This discipline also offers insights into market anomalies, like bubbles and crashes, that can occur when collective irrational behavior drives asset prices far beyond their intrinsic values.
HH is hosting a virtual event on March 6th to help clients further their knowledge of behavioral finance – including, importantly, strategies designed to help mitigate biases. You’ll learn practical methods to recognize and contend with biases to help you make more reasoned investment choices. Please join us! To learn more and to register, please click here or contact us directly at HHTeam@hhga.com.
Disclosure:
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant. All opinions or views reflect the judgment of the author as of the publication date and are subject to change without notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted.
