Behavioral finance theory: Keeping emotions separate from investing

Ask the average investor what factors they think most affect the performance of their portfolio and you’ll likely hear answers such as the overall health of the economy, whether stocks are in a bull or bear market and how their assets are allocated.

What they usually won’t list are their own emotions, personal biases and preconceived notions about money and investing. But these and other psychological factors can cause investors to make decisions that adversely affect their portfolio’s performance and work against their own best interests. This is where behavioral finance theory comes into play, highlighting how behavioral biases can impact investment decisions and overall financial decision making.

WHAT IS BEHAVIORAL FINANCE?

Behavioral finance is the study of how different psychological factors influence the decision-making process of investors. It's been said that the origins go back more than 150 years with concepts of market psychology from the publication in 1841 of the book Extraordinary Popular Delusions and the Madness of Crowds, which described the way investors acted during various financial bubbles and corrections. This historical perspective shows that human behavior has long influenced financial markets and investor’s perceptions of market dynamics.

But the modern version of behavioral finance theory was developed in 1979 when Nobel Prize-winning psychologists Amos Tversky and Daniel Kahneman came up with prospect theory. This theory is based on the assumption that investors value gains and losses differently and that the emotional impact from a loss is much more severe than from an equivalent gain. This phenomenon is also known as loss aversion, a type of irrational behavior that can lead to suboptimal investment decisions.

BEHAVIORAL FINANCE EXAMPLES

To illustrate how this works in the real world, Kahneman offered his students a proposition. He’d toss a coin and if it landed on tails, they would lose $10. Then he asked the students how much they’d need to win if it landed on heads. Most students required a payout of $20 – double what they stood to lose – to take the bet. This demonstrates how behavioral biases affect our willingness to take risks and make rational decisions.

To prove that the effects of prospect theory don’t change based upon income, Kahneman offered a similar proposition to successful executives; only they would lose $10,000 on a flip of tails. Yet they, too, required double the loss, $20,000, to take the bet. This highlights how even experienced market participants are influenced by psychological biases and can make irrational financial decisions.

This loss aversion can play out in several ways for investors.

For example, many investors won’t concern themselves with their investment portfolio as long as it’s going up, and for months, even years at a time, will pay little attention to the stock market. But those same investors, when the market enters a period of volatility and uncertainty – spurred on by the emotional impact of losses in their portfolio – will panic and sell their holdings, usually right around the time the market bottoms. What this illustrates is a herd mentality and how behavioral factors can negatively influence investment strategies and financial management.

Those same investors may avoid buying back in when the market rallies because they don’t want to pay higher prices than what they sold for or fear that if they do, the market will turn and drop again. So, they just sit on the sidelines and watch as the market goes back to its old highs—and beyond. This kind of irrational decision making can significantly impact long-term investment management and overall financial planning discipline.

It’s not hard to imagine. Think of the investors who, because of loss aversion, sold their portfolios on Black Monday in 1987 when the stock market dropped 23% … or in early 2000, when the dot-com bubble burst … or during the 2007 financial crisis … or even recently, in March 2020, when the S&P index dropped 34% due to the COVID-19 pandemic. Events like these show how we can be influenced by collective investor behavior and human psychology.

In every one of those cases, the stock market eventually recovered, and though past performance doesn’t guarantee future success, those investors who sold out at the bottom and never reinvested missed out on the recovery. This underscores the importance of making rational decisions and the dangers of succumbing to psychological biases in times of market stress.

ADJUSTING BEHAVIORAL BIASES

So, what can you do to help make sure that your emotions don’t derail your investment goals? Unfortunately, it’s very much an uphill battle.

The underlying psychological biases that drive our emotional relationship to money could have been formed and reinforced over hundreds of thousands of years of human evolution, and there is no easy way to “flip the switch” to change them or turn them off.

Having set financial goals and using an “automated” system like dollar-cost averaging can sometimes help minimize the impact of emotions on your investing, but unless you’re going to avoid all news and social media for the rest of your life, there’s no way to avoid knowing when the market is in a volatile period – and that could potentially cause you to make a rash decision about your investments. Implementing sound risk management techniques and adhering to a disciplined investment strategy can help mitigate these challenges.

A better option is to rely on a professional, experienced financial advisor. Someone whose job is to be objective about your investments when you can’t be. But make sure that your advisor has two vital attributes: a disciplined investment approach and the experience to know how important it is to stick with it during difficult times. They should understand both traditional finance theories and the insights from behavioral finance to guide you effectively.

If your advisor doesn’t have a disciplined investment approach or they don’t have any experience navigating volatile markets, they may panic as much as the average investor. There are several questions you can ask your advisor about their approach or strategies for difficult markets. If your financial advisor doesn’t have a long-term strategy for your investments, contact us at Edelman Financial Engines. Our team’s expertise in investment management enables us to help clients make rational decisions that align with their long-term financial goals.