Most stock market theories try to predict how the market behaves. However, our own emotions influence our investment decisions, causing us to behave in illogical ways. When clients first come to us, we often see how emotional biases have influenced their portfolios. Behavioral Finance is a moderately new study that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make the investment decisions they do. Learning to recognize the emotional biases can help prevent investors from making mistakes.
Confirmation Bias
We often say “seeing is believing,” because our minds have a tendency to form opinions when processing certain kinds of information. Consider how we make first impressions when meeting someone new. Some investors apply this same feeling to an investment. We hear about a “hot stock” then choose to research the stock in order to “prove” its reputation is deserved. As we find confirming information like a low debt to equity ratio, we also tend to ignore the red flags that might mean the company’s financials are in peril. This is how confirmation bias works.
Hindsight Bias
A hindsight bias is the belief that past events were predictable and could have been avoided. No one could have predicted that an earthquake would affect Japan in early 2011. Likewise, many market bubbles were not obvious at the time, otherwise it wouldn’t have escalated and eventually burst.
Overconfidence
We also see many investors suffer from overconfidence, believing they are better than other investors when it comes to picking stocks or knowing when it is best to enter and exit the market. The reality is that it is very difficult, if not impossible, to time the market. Only in hindsight do we learn when the market’s highs and lows occurred. Strategies like dollar cost averaging can help investors obtain the best price over the long term.
Mental Accounting
Another trap people may fall into is the misleading notion of mental accounting, or treating money different because it comes from a different source or is intended for a different purpose. Consider how you may have spent your last bonus. Did you consider it “found money,” and decide to buy something you wanted rather than pay down credit card debt? Investors often do similar mental accounting tricks by dividing their portfolio into separate accounts, keeping their speculative investments away from their more conservative investments. In reality, the investor’s net worth is no different than if all their money is in one account.
Anchoring
Investors may also attach or anchor their beliefs to a reference point no matter how or where that reference point came from. Finance textbooks like to site the widely known concept that a diamond engagement ring should cost two months’ salary, when in fact, this reference point was invented by the jewelry industry. In the stock market, if ABC company doubled profits last year and the stock price shot from $45 to $100, investors will continue to believe the stock is worth $100 per share despite any news to the contrary. When the stock drops to $50, investors who have an anchoring bias will believe it is undervalued when the change may be due to a change in the fundamentals of the company.
Gambler’s Fallacy
The gambler’s fallacy is the belief that the odds for something with a fixed probability increase or decrease depending upon recent occurrences. Past events do not change the probability that certain events will occur in the future. Under the gambler’s fallacy, an investor believes he should sell his stock in company ABC after it has risen in price for several consecutive trading sessions because he doesn’t believe that the stock could continue to go up. Conversely, an investor might believe it would be improbable for a stock to continue to fall, so he holds on to it much longer than he should.
These are just a few of the common human behaviors that can affect investors when it comes to making decisions on their investments. At Henssler Financial, we believe you should Live Ready, and that includes developing purchase and sell criteria that you follow regardless of market conditions. When researching stocks for investment, consider the fundamentals of the company, but remember that past performance is not indicative of future results.
If you need help taking the emotion out of investing, consider consulting a financial adviser. The experts at Henssler Financial will be glad to help you. Give us a call at 770-429-9166 or email at experts@henssler.com.
Disclosures:
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.
