Behavioral Finance: Navigating the Psychology of Investing
You’ve likely heard the term Behavioral Finance over the last few years, whether it is for a Nobel Laureate’s awarding winning research, a webinar we hosted with Daniel Crosby Ph.D., or a topical news article in the Wall Street Journal. The burgeoning field and its efforts to better harness our inner impulses have moved from the theoretical work in academia to center stage today. Whether it’s AI looking to identify those human clues in the data or your advisor trying to talk you off that ledge, if we better understand ourselves and our tendencies we are destined to be more successful investors. Much like the question about the chicken and the egg, our actions and impulses have as much influence on the market as markets themselves do on our moods and decision making. An easy analogue is the rise of the influencer economy where platforms like TikTok, Reddit (meme mania) or a celebrity promoting a brand (Dunkin Donut’s anyone) or has captured the imagination of the general public and often time the viral effects that a large and growing network can manifest. With the market, I can think of no better example than Tesla and their mercurial genius founder. It’s hard to argue that the company has not created a truly differentiated driving experience, which has spilled over to impact decisions at all of the major automobile manufacturers' mainstream. We know of the recent problems with EVs but it’s irrefutable that tectonic shift has occurred. With TLSA, back in 2010 the stock was priced at $17 at IPO and opened at $19, 13+ years later after undergoing two splits (5:1 in 2020 and then 3:1 in 2022). An original $5000 is now worth $882K based on the stock trading at $200/share. How much of their success has been about the stock price itself and how much of the stock price is about the product they make will be debated for many years ahead. Let’s get into the specifics of this field of psychology...
Overconfidence: Humility vs. Hubris
Keeping overconfidence in check is essential for investors to maintain a realistic assessment of their abilities, diversify their portfolios, conduct thorough research, and remain open to feedback and new information. Additionally, having a well-defined investment strategy and risk management plan can help investors make more informed and rational decisions.
- Overtrading: Overconfident investors may excessively or even day-trade stocks, believing they can consistently time the market or pick winning stocks. This frequent trading can lead to higher transaction costs, taxes, or outsmarting oneself, eroding overall returns.
- Failure to Diversify: Overconfident investors may concentrate their investments in too few stocks or a specific sector, underestimating the potential risk of loss. Lack of diversification can expose the portfolio to significant losses if the chosen stocks or sector underperform. This can also impact the total return of the portfolio if other sectors carry the market higher over a period of time.
- Ignorance of Risks: Overconfident individuals tend to underestimate the risks associated with their investment decisions. This can lead to a lack of thorough research and due diligence, resulting in unexpected losses when adverse events occur.
- Inability to Admit Mistakes: Overconfident investors may find it difficult to admit when they are wrong. This reluctance to acknowledge mistakes can lead to holding onto losing positions for too long, amplifying losses or just missing other, more profitable investment opportunities.
Herd mentality. Yes there is wisdom in crowds, but not when it comes to irrational behavior.
Herd mentality, or the tendency of individuals to follow the actions of the majority, can have both positive and negative effects on investors in the stock market.
Positive Aspects:
- Momentum Trading: In some cases, herd mentality can contribute to momentum trading. If a particular stock or asset is experiencing positive momentum, a herd of investors may join in, driving prices higher. This can create opportunities for short-term profits for those who act early and ride the momentum.
- Market Efficiency: Herd behavior can contribute to the overall efficiency of financial markets. As information spreads and a consensus forms among investors, prices can quickly adjust to new information, reflecting the collective wisdom of the market participants.
Negative Aspects:
- Bubble Creation: Herd mentality can contribute to the formation of speculative bubbles. As investors collectively chase a particular asset or sector, prices may become disconnected from fundamentals, leading to overinflated valuations. When the bubble bursts, significant market corrections can occur, causing substantial losses for those who bought in, near or at the peak.
- Exaggeration of Trends: Herd behavior can exaggerate both upward and downward market trends. When a trend is established, more investors may join in, amplifying the trend. This can lead to overvaluation or undervaluation of assets, making markets more susceptible to sudden corrections.
- Panic Selling: In times of market uncertainty or downturns, herd mentality can result in panic selling. As investors see others selling, they may feel compelled to do the same, leading to a cascade of selling activity. This can contribute to market crashes and exacerbate declines.
Loss aversion: Volatility is not synonymous with risk, understanding that is critical.
Loss aversion refers to the psychological phenomenon where individuals experience a more significant emotional reaction from losses than from equivalent gains. In the context of investment portfolios, loss aversion can have several negative effects on both performance and decision-making:
- Reluctance to Sell Losing Investments: Investors who are highly loss-averse may be reluctant to sell investments that are experiencing losses. They may hope that the market will recover, believing that it is only a loss on paper and that it will come back. This reluctance to cut losses can prevent portfolio rebalancing and limit the ability to reallocate funds to more promising opportunities for investment.
- Delayed Decision-Making: Loss-averse investors may procrastinate when faced with the decision to sell a losing investment or make changes to their portfolio. This delay can result in missed opportunities to minimize losses or capitalize on more favorable market conditions.
- Suboptimal Asset Allocation: Loss aversion can influence investors to maintain a portfolio that does not align with their timeframe or financial goals. They may prefer to hold onto familiar assets or investments that have not yet realized losses, even if reallocating funds to different assets could improve overall portfolio performance and help them to better manage risk.
- Inability to Stick to a Long-Term Strategy: Long-term investment strategies often involve temporary fluctuations and market downturns. Loss-averse investors often make impulsive decisions based on short-term market movements rather than sticking to a well-thought-out plan.
- Missed Investment Opportunities: Fear of potential losses can lead investors to avoid new investment opportunities altogether, even if those opportunities align with their long-term goals and risk tolerance. This overly conservative approach often leads to long-term underperformance and can limit a person’s financial options.
Buy what you know.
This seemed like sage advice from a revered investor like Peter Lynch, but it does have its limitations. What if you have a spectacularly deep understanding of the energy sector? During the pandemic, the whole world reduced energy consumption in large part because we were locked in our homes. Exxon as an example was down over 41% in 2020. This happened, all the while many companies actually benefited from their workers being at home. Even a company like Etsy outperformed, making $60 Million+ on handmade masks through September of 2020. If your area of expertise was Etsy and you owned the stock, you were up 184%. Either positively or negatively, this is a HUGE swing that can be felt in your returns for years to come.
Recency bias.
Looking at a chart this quarter or over the trailing twelve months may lead investors to chase past performance, assuming that a stock's recent success will continue. However, markets are dynamic, and past performance does not guarantee future returns. This behavior can result in buying stocks at inflated prices and missing the EV, Artificial Intelligence or Lululemon-like crazes that come and go.
In conclusion, the pervasive influence of Behavioral Finance on financial markets and individual investments cannot be overstated. As we've observed with Tesla's meteoric rise from the fringe to the mainstream, the power of trends, celebrity endorsements, and public sentiment can reshape entire industries and even our economy at large. While Behavioral Finance can serve as a driving force for positive growth, it also carries the potential for pitfalls that may hinder portfolio development. Acknowledging and understanding these dynamics is paramount for investors seeking to navigate the complexities of the market. By a well thought out and executed financial plan, one can harness the potential for informed decision-making and, ultimately, strive for a more resilient and successful investment journey in an ever-evolving landscape.