When it comes to money and investing, we are not always as rational as we think. In our sometimes strange behavior, there are many interesting things that require study and explanation.
Economic theory is largely based on the assumption that people act rationally, and that all existing information is included in the investment process. This assumption is based on the so-called hypothesis of market efficiency.
However, researchers who dared to question such an assumption, found evidence that rational behavior does not always prevail, as is commonly believed. The theory of behavioral finance tries to understand and explain how human emotions affect the investor's decision-making process. Their findings will surprise you.
In 2001, Dalbar, a financial services research company, released a report called Quantitative Investor Behavior Analysis. It concludes that the average investor is not able to achieve profitability indicators of market indices. It was revealed that for the 17-year period until December 2000, the S&P 500 index showed an average return of 16.29% per year, and a typical investor in stocks for the same period had a return of only 5.32%. The difference is frightening – 9%!
It also turned out that over the same period, the average investor in fixed income securities received only 6.08% per annum, while the index of long-term government bonds brought 11.83%.
In a more recent version of the same report for 2015, the company again comes to the conclusion that the average investor is not able to achieve profitability indices of market indices. According to the data, "the average investor in mutual funds lagged behind the S&P 500 by 8.19%. The return on the broad market was more than twice as high as the average return on investors in mutual funds (13.69% versus 5.50%)."
The performance of investors in mutual funds of fixed income securities was also not at the highest level – by 4.18% below the bond market.
Why it happens? Here are a few possible explanations.
Fear of regret, or simply the theory of regret, is connected with the emotional reactions of a person when he realizes that his reasoning was erroneous. Faced with the prospect of selling a stock, investors experience emotions that depend on the price at which they bought the stock.
Therefore, they try not to sell the stock in order to avoid regrets that they made a bad investment, and emotional discomfort associated with the actual loss. We all really dislike being wrong.
When thinking about the possibility of selling a share, the investor should ask himself the question: “If this position was already closed, is this paper good enough to enter it again?”
If the answer is no, then it's time to sell. Otherwise, you will regret that you bought a losing share and that you did not sell it when it became clear that this investment decision was bad. It turns out a vicious cycle when the desire to avoid regret leads to even greater regret.
The regret theory is also true for investors who discover that the stock they were only considering buying has risen in value. Some investors try to avoid such regrets, guided by ordinary worldly wisdom and buying only those shares that everyone buys. They argue with such a decision that "everyone does it."
Strange, but many people feel more comfortable losing money in popular stocks that half of the world's investors have, and not in some little-known and unpopular papers.
People tend to place certain events in certain mental departments, and the difference between these departments sometimes affects our behavior more than the events themselves.
For example, suppose you want to go to a theater show and the ticket costs $ 20. When you arrive at the theater, it turns out that you have lost a $ 20 bill. Will you, despite this, buy a ticket for $ 20?
According to the conclusions of the theory of behavioral finance, about 80% of people in a similar situation would buy. Now suppose you bought a ticket for $ 20 in advance. Going to the door of the theater, you understand that you left the ticket at home. Will you spend $ 20 to buy another ticket?
Only 40% of respondents are ready to do this. But note that in both cases your expenses will be $ 40. Although the amount is the same, situations are different and they fall into different mental departments. Pretty stupid, right?
With regard to investing, the best illustration of such a mental accounting is the doubt about the sale of an investment in a share, which made a huge move earlier, but now demonstrates rather modest growth. During periods of economic boom and bull market, people get used to big profits, even on paper. When the correction begins to negatively affect the profit of investors, they do not dare to sell the position with less profit. They put the potential profit that they had in a certain mental department and wait for the income period to return.
Theory of Prospects / Losses
You do not need to be a neurosurgeon to know that people prefer guaranteed return on investment uncertainty. Taking risks, we want to receive a reward for this. This is quite reasonable.
But here is the strange thing. The theory of perspectives shows that in relation to profit and loss, people show emotions to varying degrees. The stress associated with the prospect of a loss is greater than the joy of seeing a profit of the same magnitude.
The client will not annoy calls to his investment advisor, who reported that the paper profit is $ 50,000. But there is no doubt that the phone will ring without ceasing after the client finds out that he is shining $ 50,000 loss! Loss always seems to us more than potential profit of the same magnitude. When money settles in our pocket, its value changes.
Prospect theory also explains why investors maintain their losing positions: people are willing to take more risks to avoid losses than to make a profit. For this reason, investors are prepared to remain in risky positions in the hope that the price will return. Casino players behave similarly during a series of losses. They double bets to win back what they lost.
Thus, despite the rational desire to receive a reward for the risks that we assume, what we already have, we, as a rule, value more than we would be willing to pay for it.
The theory of loss aversion indicates another reason why investors can maintain their loss-making positions, but sell profitable ones. They believe that stocks that fall today can grow faster tomorrow than stocks that have grown today. A common mistake made by investors is to chase the market by investing in the stocks or funds to which the most attention is drawn. Studies show that the influx of money into mutual funds with high financial performance is faster than the outflow of money from funds with low performance.
In the absence of better or newer information, investors begin to consider the market price correct. People rely too much on recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical long-term averages and probabilities into the future.
In a bull market, investment decisions are often influenced by being tied to some price levels, which are considered important because of their proximity to recent prices. Thus, the longer-term behavior of the stock is less likely to affect investor decisions.
Excessive / Inadequate Response
When the market grows, investors become more optimistic and act on the assumption that growth will continue. Conversely, during periods of recession, investors become extremely pessimistic. The consequence of being obsessed or giving too much importance to recent events while ignoring historical data is an excessive or insufficient response to what is happening on the market. This leads to the fact that on bad news the price falls too much, and on good news it rises too much.
At the peak of optimism, the greed of investors drives the price of stocks to unjustified heights. Since when has the decision to invest in a stock with zero profit, without considering the risk / profit ratio, become rational? A typical example is the era of dotcoms in the 2000 area.
In extreme cases, excessive or insufficient response to market events can lead to panic and collapse.
As a rule, people assess their capabilities as above average. They also overestimate the accuracy and scope of their knowledge compared to other people.
Many investors believe that they are able to stably choose the right moment to complete transactions, however, practice gives a huge amount of evidence to the contrary. Excessive confidence leads to over-trading, as a result of which commissions eat up a significant part of the profit.
Is irrational behavior abnormal
As mentioned above, the postulates of the theory of behavioral finance directly contradict the traditional science of finance. Each of the opposing camps is trying to explain the behavior of investors and the consequences of such behavior. So who is right?
The most explicit opponent of behavioral finance theory is the market efficiency hypothesis created by Eugene Fama (University of Chicago) and Ken French (Massachusetts Institute of Technology). Their theory, which states that the market price effectively takes into account all available information, is based on the assumption that investors act rationally.
Proponents of this hypothesis argue that the events that are considered by the theory of behavioral finance are only a short-term anomaly or luck, and that in the long run, such anomalies disappear when the market becomes effective again.
Thus, the arguments in favor of abandoning the theory of an effective market are not enough, since there is empirical evidence that the market seeks to correct itself in the long term. In his 1995 book Against the Gods: A Noteworthy Risk History, Peter Bernstein (Peter Again, Against the Gods: The Remarkable Story of Risk) successfully expressed the essence of these controversies:
"Although it is important to understand that the market does not work as classical models describe (there are many manifestations of crowd behavior – the concept of the theory of behavioral finance, according to which investors act irrationally and in the same direction), how to use this information to manage money, I don’t know. I have no evidence that anyone is able to consistently make money on this. "
The theory of behavioral finance certainly reflects the opinions present in the investment system. Its supporters argue that investors often behave irrationally, which makes the market inefficient and leads to the appearance of incorrect quotations of securities, not to mention the fact that this creates opportunities for earnings.
At a particular moment, this may be so, but it is difficult to consistently identify such inefficiencies. Questions remain as to whether this theory can be used for effective and economically viable management of its capital.
Thus, the main enemy of the investor is himself. Attempts to predict the market are not justified in the long run. In fact, they often lead to strange, irrational behavior, not to mention the erosion of capital.
Only the development and adherence to the rules of a well-designed strategy can help the investor avoid many common mistakes.