Streetwise for Friday, March 8, 2019
Once again, I want to address a favored topic among both my students and clients. Despite the continual gains available in recent years, individuals exited the market, an action diametrically opposite to that of many institutional investors. The question is why?
One crucial reason institutional behavior is contrary that of individuals is that professionals generally maintain strict series of rules and objectives. The result is an enforcement of a disciplined investment style or strategy. Individuals, on the other hand, will often allow their emotions to dictate their actions.
Therefore, understanding the emotional biases that might adversely affect your portfolio can be an important step toward improving your investment performance. By shaking off the behavioral predispositions that are potentially distorting your investment decisions, you will be better positioned to take advantage of expected returns and thereby realize improved portfolio performance.
What I am describing is behavioral finance, a field of study that combines psychology with economics and finance to try and explain why investors often fail to make optimal investment decisions. For example, consider two behavioral biases: the availability heuristic and the concept of loss aversion.
The “availability heuristic” suggests that investment decisions are made based on easily recallable events. For many, the 2008 financial crisis left its mark on the psyches of many because it was unexpected, sudden and dramatic. Despite the steady recovery that we have seen over the past eight years, the financial crisis left scars. Thus, many individuals are more risk-averse than they were before the crisis.
Behavioral finance has shown that “loss aversion,” creates a greater sensitive to losses than the excitement generated by potential gains. This in turn has kept investors more focused on how much they could lose in the short-term, rather than on how much they could gain if they stayed the course.
Yes, we would like to blame Wall Street for our lack of investment sophistication but remember, “We have met the enemy and he is us.”
Of course, Wall Street’s insatiable greed that comes at the expense of Main Street, must also end. However, the answer is not that we mimic the French proletariat and bring back the guillotine.
What we are facing is an educational issue more than anything else. Remember that patently false or irrelevant information can significantly affect peoples’ choices.
This was unequivocally demonstrated by psychologists Daniel Kahneman and Amos Tversky. They had subjects spin a wheel that supposedly would stop at random on any number between 1 and 100. The subjects were then asked what percentage of African countries belonged to the United Nations.
For one group the wheel was rigged to stop on 10; for a second group on 65. On average, the first group guessed that 25 percent belonged to the United Nations, while the second group guessed 45 percent.
While the subjects would have insisted, that the number on the wheel bore no relation to their answer, the number did profoundly influence the responses given. In short, even demonstrably false or irrelevant information can influence both your judgment and your decisions.
Consider the research carried out by Swiss behavioral scientist Jean Piaget in 1940. With children as an audience, Piaget formed clay into two balls that the children agreed were of equal size. Then he rolled one of the balls into a sausage shape. When asked to compare the sizes again, almost every child insisted that the two objects were no longer equal in size.
Per Piaget, the children were so transfixed by the dramatic change in the clay’s dimensions that they were unable to recognize that the clay’s original mass had been preserved.
Peoples’ perceptions of money are similar. Like the children, they become so transfixed by changes in the dimensions of an investment, either in time or size that they refuse to believe its actual value.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.