Last week, I talked about how investor psychology affects our behavior and then, in turn, affects our investment performance. Let’s continue by looking at some more examples of how investor behavior can be influenced by psychology.
When times are tough, we tend to think they will get even tougher. When investments make money, we tend to think they will keep making money and we tend to do this in a straight line. Let’s say you have three investments in your portfolio and you review these investments a year later. One investment makes 10%, one breaks even and the last investment loses 10%. It is natural that your first instinct is to get rid of the loser and buy more of the winner. We think that since an investment makes 10%, it has a better likelihood of continuing to make 10%. I call this chasing performance which is one of the most common investment practices. Unfortunately, the reality is that everything goes in cycles and thus you have a better chance if you sell some of the winners to buy some of the losers.
Let’s say you are about to buy some $50 speakers for your computer and you see an ad that there is a sale on speakers for $25 but the store is on the other end of the city. Would you drive the extra distance to save 50%? What if instead of $50 speakers you were looking to buy a complete computer system for $1500 and there was a sale for the same computer for $1475. Now would you drive the distance to save $25? In both examples, you are saving $25 yet we are more inclined to drive the distance for the speakers as opposed to the computer system. Framing refers to how our views and decisions are influenced by the way a situation is framed. Framing changes our perceptions and thus affects our decisions. In the context of investing, sometimes investments can be framed or described in a different context. For example, if you are comparing an investment that made 2% to an investment that made 15%, you might not view that 2% investment very positively. However, let’s say a year later that same 2% investment still made 2% but the other investment was now down 10%. What do you think of the 2% investment now? What if that 2% investment was a boring GIC? We love GICs when markets are down but we have a different perspective when alternative investments are shooting the lights out despite the fact it’s the same investment (just framed differently).
Another common psychological influence in investing
is overconfidence. One of the most common occurrences is that when markets are going up, we think they will continue to go up and we become overconfident about our abilities. When markets were on the rise in the late 1990s how many investors made good decisions and thought that they were the reason behind the good fortune. The reality is that almost all investments made money because the markets worked in our favor. However, I know many investors that became overconfident in their abilities. Overconfidence tends to cause us to believe that we have more control than we really do. As a result, we can often see only the information that supports our beliefs and ignore information that goes against the thesis.
Fear of loss.
It has been said that we feel the pain of losing money twice as much as the pleasure of making money. Finding $50 on the ground is pretty gratifying. However, reaching in your pocket to realize that you have lost $50 is extremely upsetting.
In investment terms, behavioral finance states that there is an inconsistent appetite for risk. We see this with these risk profile questionnaires. Investors are asked to complete a questionnaire with 10 to 15 questions and the results then determine the appropriate type of portfolio for the investor. Although I understand the basis for these questionnaires, the problem is the results are based on how we feel and the problem with that is you can fill these questionnaires out at two different times and come up with two different results. When times are tough, we are inclined to take less risk because we fear loss.
We are more likely to take risks when times are good because the rewards support the risk. Unfortunately, the higher the markets go the greater the risk of a correction. We are less inclined to take the risk when markets are down yet logically, these are the times to take risks.
Related article: Investing is all starting to look the same
So what’s the point to all this psychology?
The bottom line is that our minds will forever play tricks on us because our emotions get in the way of making logical decisions. My hope is that if you are aware of some of the psychological influences to investing, it may help you to avoid some very common behavioral mistakes. I’ll end where I started. It has often been said that people spend too much time studying investment behavior and not enough time focusing on investor behavior. Regardless of what investment does, it is the decisions of the investor to buy or sell that ultimately determines success or failure. Good luck!