Behavioral Finance — What's behind Your Investing Decisions?

By Dianna Doreen
Writer, mPower

Are you overconfident? You may be, if you believe:

• You are a safer driver than average.
• You perform your job better than most of your colleagues.
• You are better than most people at identifying market trends, or picking winning investments.

Behavioral economists are finding that people act irrationally when it comes to dealing with their money and their investments. They put too much untested faith in themselves. Indeed, as much as 80 percent of those surveyed answered "yes" to the above questions.

But, how is this possible?

Don't economists tell us that the financial markets are efficiently priced and that investors are acting rationally? Any exuberance in the financial markets must therefore have been, strictly speaking, rational. Right? As it turns out, quite a few economists have now come to realize something the rest of us knew all along, that human beings are often irrational.

In fairness, what they have realized is not just that human beings are often irrational, but that if economic theory is to provide an adequate description of human economic behavior, it needs to take human irrationality into account. A number of respectable financial economists now work in a field called "behavioral finance."

Are You Fiscally Overconfident?

Issues regarding the nature of economic theory are likely to seem too academic to interest most of us. But, there may be something of importance here: If irrational thinking is influencing our investment and retirement-planning decisions, this could potentially cost us a great deal of money. Allow me to put this in logical form, so it does not escape even the most rational among you:

• Human beings are vulnerable to irrational thinking.
• You are a human being.
• Therefore, you are vulnerable to irrational thinking.

Let me guess what you are thinking right now: You agree with the first premise but not with the conclusion. You feel you're exceptional, more rational than anybody you know, right?

Aha!

This is an instance of "overconfidence," a cognitive bias that has been widely documented by psychologists. Incidentally, that particular form of irrationality has recently been used to explain why investors trade excessively, even though this is contrary to maximizing their investments.

Behaving Irrationally

Perhaps the best way to illustrate irrationality in human beings is to consider the results of some experiments formulated in the 1970s by Amos Tversky and Daniel Kahneman. Both are pioneering cognitive psychologists whose research laid the foundation for much of the current understanding of behavioral finance.

What did they discover?

That the principles guiding human decision making bear little resemblance to formal rules of logic or valid statistical inference that modern society holds so dear.

Let's take the case of Linda.

Linda is 31, outspoken, and very bright. She got her college degree in philosophy, is deeply concerned with discrimination and other social issues, and participates in anti-war demonstrations. Which statement is more likely to be true?

• Linda is a bank teller.
• Linda is a bank teller and active in the feminist movement.

In a Tversky and Kahneman study, 87 percent of those surveyed judged that "b" is an answer more likely to be true than "a." But, this violates both a very basic law of statistics and a basic principle of logic. If Linda is a bank teller and active in the feminist movement, she is a bank teller.

One of the laws of statistics is that the odds of any two uncertain events happening together is always less than the odds of either happening. So "b" is not more likely than "a."

We tend to make this mistake because we are relying on a principle cognitive psychologists refer to as "representativeness." The description of Linda just sounds more like someone who is involved in the feminist movement than like someone who is a bank teller.

What does this mean for behavioral finance? Researchers have observed in behavioral finance that the principle of representativeness can lead even sophisticated investors into making poor decisions.

Another study, for example, demonstrated that professional investors have a strong tendency to overestimate the probability that a good company has a "good" stock.

The diagnosis of this particular investor error — an excessive reliance on representativeness — was presented in detail back in 1993 by Hersh Shefrin and Meir Statman, at the Institute for Quantitative Research in Finance, in their study A Behavioral Framework for Expected Stock Returns.

Good companies are, after all, to investor perception, similar to good stocks — even if they are not exactly the same things.

The Investor's Perceptions

An investor's perceptions, whether positive or negative, can skew their cognitive judgment.

For an in-depth example of how negative or positive perceptions guide decision-making ability, read about the general's decision.

The story of the general's decision illustrates how, as a rule, people are much more sensitive to losses than to gains. Losses tend to have a greater emotional impact than gains. And as a result, we are willing to take much more risk to avoid losses than to secure gains.

The relevance of this effect to investment decisions is obvious.

This particular phenomenon, the willingness to take risks to avoid losses, has been used to explain why some people buy more shares of their losing stocks as the prices fall even farther.

Because of the perception skew, investors are willing to take on more risk to avoid facing a loss than they are willing to take on in order to realize a gain.

Your Behavior and Your 401k

So what does all this have to do with your 401k plan?

The important lesson here is that our instincts tend to be a less-reliable guide than we would like to believe.

Trusting your gut when it comes to investments is unlikely to lead you to maximizing your risk-adjusted returns.

It may seem obvious to you that you should maximize contributions to your 401k, but things get more complex when determining in which funds to invest. And, when it's time to decide which funds to use, you may have apparently sound reasons for your convictions:

"Technology is the future ...
... value has under performed for so long it is bound to bounce back ...
... long-term growth will come from the developing markets ...
... bonds are the place to be with stocks headed for a long, overdue bear market ... etc."

Just remember that any such judgment, no matter how high you feel your level of confidence is, may well be wrong.

Applications of Behavioral Finance

Things to watch for in your own investment reasoning include excessive fund switching and avoidance of risk. Further, investors should be stubborn when it comes to their investment plan and determined goals — and not regret decisions made to stay the course of this plan.

Most people rate their abilities and prospects higher than those of their peers. They also don't often recognize the tendency to practice regret over investment decisions, rather than move on and invest in a way that better suits their goals.

Investors may perceive, and this is usually a perception based on hope, that a bad investment has got to turn better. But, despite the often-held notion that investing is like gambling, an investment's performance and hope are not proven in any scientific way to be aligned with one another.

Recognizing tendencies like these is key to understanding why we make the financial decisions we make. And, investing from a place that takes into account such perceptions, rather than blindly investing how we feel, is the main application of behavioral finance.

Knowing the behavior behind your financial decisions can help shape up not only your decisions, but also, possibly out of this change in investing behavior, your investments' subsequent performance.