Why Do We Make The Investment Decisions We Do?

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Buy low, sell high. That is what we are told to do. Intuitively, it’s what makes sense to make money. After the S&P 500 index (a representation of the 500 largest companies in America) topped at 3,386.15 points intraday on Feb. 19 this year, investors sold, driving the index to this year’s low of 2,191.86 — a drop of more than 35 percent. Since then and as of June 5, buyers have driven the S&P 500 up to 3,193.93 — an increase of more than 45 percent off the bottom. So, why then did some investors continue to sell lower and lower, missing out on the ensuing recovery?

To a large degree, we humans have been programmed to avoid pain. If we touch a hot pan, our nerves tell us to withdraw immediately to stop hurting. That’s a lightning-quick physical response, but given time to think, wouldn’t we make more logical decisions with our money?  Not always. There are more thoughtful processes (mental shortcuts called heuristics) that run through our minds when decision making. Often, these shortcuts leave gaps, which can have a negative effect on the results of our decisions. We call these gaps a cognitive bias, and they are really hard to avoid — even for seasoned investors. For more than 100 years, researchers have looked into those biases in consumer and financial decisions developing the field of behavioral finance.

This article cannot do justice to all the contributions of those researchers, but I will do my best to highlight some of my favorite insights:

  1. Anchoring bias is using an arbitrary number as an anchor for a decision. For example, using the price you paid for a stock to determine whether to sell or not, regardless of the changing circumstances or projected future of the company.
  2. Regression to the mean is the tendency to extrapolate small sets of data into future results. So often, investors make a decision on where to place their money based on what went up most recently. The reality is last year’s winner may not be this year’s winner. According to DALBAR, from 1995 to 2015, the S&P 500 returned an average annual return of 8.19 percent while the average equity mutual fund investor return was only 4.67 percent. Many experts attribute that difference to investors chasing returns.
  3. Confirmation bias happens when one searches for and puts more weight in evidence that backs their opinion, ignoring alternative evidence.
  4. Regret aversion is caused by the feeling that taking an action and losing is worse than doing nothing and losing, often seen during a market is dropping and fear rules.
  5. Overconfidence and optimism bias occurs when one does not take into account the risk in a situation and causes an investor to take greater risk than is prudent. This can often happen when the market is rising rapidly and greed becomes a primary motivator.

Prospect theory, developed by Daniel Kahneman and Amos Tversky in 1979, challenged the often referenced expected utility theory developed in 1944 by John von Neumann and Oskar Morgenstern, who surmised that people make rational decisions with their money. In prospect theory, people make irrational decisions often due to loss aversion, which essentially summarizes that people feel pain twice as much as joy for the same utility. Stated simply, losing a dollar hurts twice as much as gaining a dollar.

Lastly, investors often hyperbolically discount future events while magnifying today’s events. In other words, we think today’s joys or pains will be greater and last longer than tomorrow’s joys or pains. That way of thinking leads us to make more impulsive decisions and less likely to prepare for the long-term.

My advice is to find a balance between living for today and preparing for tomorrow by working with a professional to help you develop a plan and build discipline to achieve your life’s goals. Making investment decisions is not easy, but with a knowledgeable professional on your side acting in your best interest, you can move forward with more confidence and are more likely to stick to a sound financial plan.

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