Over the years, I have been friends with or worked with a lot of business owners and entrepreneurs. What’s striking to me is that the overwhelming number of people who struggle, actually do so not because of external factors, but because of themselves. What I mean is that we often inhibit our growth and ultimate success mostly by how we think. The way our mindset can affect our finances reaches into the area of behavioral finance. I’m quite convinced that behavioral dynamics in personal investing is the proverbial missing link in financial success.
Behavioral finance can refer to many things, but it is really summed up into what those of us in the entrepreneurial world refer to as “what’s between your ears.” Personally, I think that all the technical knowledge in the world and information stacked on information really have negative returns over time. Why are there 2 gazillion websites dedicated to personal finance, volumes upon volumes of books on the topic, free educational information shared by various investment brokers and an overabundance of financial firms nearly on every corner yet, on balance, people continue to struggle?
Investment Psychology: Top 5 Ways Investors Go Broke
Let’s take a look at how behavioral finance impacts investing. In this way, behavioral finance attempts to explain and understand how reasoning (again, between your ears) errors can influence investor decisions as well as market prices.
If you are familiar with the efficient market hypothesis (EMH), one of the underlying conditions to this theory is that investors are rational. Although, I am generally a proponent of EMH, I do not necessarily believe that markets are perfectly efficient. Nor can I, based on my history in the business, claim that all or even the majority of investors are rational. I have seen first hand how many investors are less than rational when it comes to their investment decision making process. Let’s look at some key areas where researchers have noted significant thinking or cognitive errors. Have you committed any of these?
#1 Mental Accounting and Aversion
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I have personally seen this occur quite a bit. Somehow people become “wedded” or personally attached to their investment. This frequently happens because people, by human nature, attach a purchase price to their investment. This leads you to “mentally account” for gains and losses, and how you emotionally feel about your investment depends on that. Unknowingly, you are forging a personal relationship with this investment, and therefore, you make the act of selling it a personal “break up” rather than a rational, investing decision. This is problematic and can also generate a phenomenon called loss aversion, where people hold on to their losing stocks and hope that “they can somehow break even.” Call it “get-evenitis”. As Warren Buffett aptly stated “the stock doesn’t know you own it. People should not get emotionally involved with their stocks.” Sounds funny, but it happens all the time!
#2 House Money
Las Vegas and Atlantic city know the game of house money all too well. Gamblers tend to be more aggressive and less risk averse when using the money they won from the casino. Investors who have profits, trade on margin, or have money that they did not directly earn also show similar traits. I hate to use gambling analogies for investing because investing is NOT gambling. But, it does show human behavior when it comes to dealing with potential risks and rewards. Keep in mind that there’s no such thing as “paper profits.” The money you’ve made is yours. All the money is yours and you should not separate it (physically or mentally) into “house” and “your” money.
#3 Overconfidence
Ever notice that everyone thinks they are the best at something? How can it be that everyone is the best? It can’t. Many of us are overconfident in our abilities, and that can be very problematic. Overconfidence sprouts its ugly head when investors end up with a lack of proper diversification (too heavy in the stock of a company you work for or the stock of local companies), and when they trade stocks frequently (research shows those who trade more, make less). Overconfidence breeds unnecessary risks and frequent losses. Be realistic about your abilities. It’s interesting that men are more likely to be more overconfident than women. Another kudos to the fairer sex.
#4 The “Hot Hand” Fallacy
Sports fans often believe that their player or team is on a hot streak. Success breeds success it seems. Surprisingly, researchers have proven that it is only an illusion. For instance, when a basketball player seems to be “hot”, you’ll find that he or she is actually not performing any better than what their actual average shooting percentages would suggest. The successful shooting is simply a clustering of success in that period of time, but still falls within their normal range. In the investment world, many people either think they have hot hands due to some recent success, or try to put money into the hands of those whom they think are “hot”. Every year, mutual funds that post strong performance records attract investors; numerous investors flock to these outfits in droves to chase returns. This happens despite the fact that “past performance is no guarantee of future results”. Research shows that many of those who were on top in previous years won’t be keeping their place in later years.
#5 The Gambler’s Fallacy
You commit the “gambler’s fallacy” if you assume that a departure from the average (or long run) will be corrected in the short run. So you feel that something becomes “overdue”. Many roulette betting systems claim that you can generate money by betting the opposite of recent outcomes (four reds just appeared, then you bet on black). But none of them work. Same is true in the investment world –- if you think (without valid analysis) that a market, a sector, or a stock is overdue, then it really is just guessing. To be right or wrong is statistically just pure chance.
Sometimes, people refer to behavioral finance as “fluff” or new age. People would rather that you “show them the money”! But, sometimes, it’s better to know what to avoid and how to maintain self-discipline if you want to be successful. As a business owner and investor, this is something I am comfortable espousing.
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{ 10 comments… read them below or add one }
Very good article.
There are a number of interpretations of EMT – many of them simply state that the value of a stock reflects all publicly available information about that stock. There are very few people who feel strongly that EMT means that the stock market is an absolute mirror of true value. The fact that stock bubbles exist would seem to directly contradict that notion, anyway.
great article ..all human psychology..as an investor i myself also have felt all of the above emotions..really i would say 10/10 good one.
This article makes a lot of good points. I like the first point best I think. I have been guilty of hanging onto dogs because we would lke to at least break even.
It takes a lot to get to a point to sell at a loss. While a loss is never a good thing, remember you can write off portions on your taxes. Also, this is a tough market right now so I would proceed with caution.
“Nor can I, based on my history in the business, claim that all or even the majority of investors are rational”
Bingo. Back when BP was at $29, I made the rare move of recommending the stock to friends. I’m not a stock analyst, so I almost never do this – in my lifetime, I’ve recommended invdividual stocks maybe 4 or 5 times. I do have a background in accounting, and looking at the company’s financial statements made me fairly optimistic about the future of BP.
It’s true that the gulf cleanup is going to be a big financial burden for BP, but given the size and financial strength of the company, it’s not likely to be a crippling blow. I felt that the price was being driven down by the news coverage. I’m not saying the news coverage was unfair, just that the length of the cleanup resulted in a lot of news coverage.
I cautioned that there might be some downturn in the near future, but that holding for 12-18 months could see some good gains. Now (6 weeks? later), the stock is above 40 (although I still see this as a long term investment.
Alas, I couldn’t convince Mrs. Kosmo that this was a good investment.
Every once in a while, you can spot stocks whose price is being artificially boosted or killed by investor over-reaction to news about the company.
one of the underlying conditions to this theory is that investors are rational. Although, I am generally a proponent of EMH, I do not necessarily believe that markets are perfectly efficient.
The amazing thing is how easy it is to fix the problem. All that you need to do to know the proper (rational) value of the market is to adjust for the extent of overvaluation or undervaluation. The fair-value P/E10 value is 14. When the market P/E10 is 28, the nominal price is two times fair vale. Just divide the number reported in the newspapers by 2 and you know the deal!
Doing this would have saved all of us back at the top of the bubble. The nominal value of the Dow was 12,000. The P/E10 value (44) told us that stocks were priced at three times fair value. So we needed to divide by three to know that the real value of the Dow at the time was 4,000.
All that has happened in the years since is that the Dow value has stayed steady or dropped a bit while earnings have continued to come in so that in time we will be back at fair value. All investors who knew this back in 2000 knew that the long-term return at that price was going to be a negative number and knew not to go with too heavy a stock allocation.
The bottom line is that the market is telling us the proper price of the Dow. Those of us who refuse to look at valuations are just refusing to take notice of what the market says. All overvaluation and undervaluation is by definition irrational. So all you need to know the rational price is how much of an adjustment to the nominal price is needed to reflect the extent of investor irrationality that applies at that time.
Rob
Good read. Knowing such financial behaviors can help one assess himself. I think that in order to do the right financial choices, it is better to ask an expert for advice and guidance.
It is interesting Rob that you mention PE at fair value. How do you determine that and which PE do you use? 12 month trailing or future? They are very different numbers. One can be calculated while the other is a best guess.
Using PE would also mean that you might have gotten out of the market during the great bull run and missed that dramatic increase. So valuation is definitely a component of stock investing but shouldn’t be the only thing to look at…especially when you are talking about individual stocks. Growth stocks can have and support higher PEs than a stable value play. Dividend yield should also be accounted for as well.
If 14 is fair value that means at times we go under that though in the past decade have we spent much time under it? I think we are in for a long period of going nowhere in the stock market. The problem is psychologically people who have them most in the market are the ones who were trained in the last Bull run to keep buying dips and the market always goes up.
The new generation won’t have that feeling as their learning experience was a roller coaster ride (bear dive, bear recovery, going nowhere, next??)
That psychology will take a long time to play out before we get another bull run like we saw in our early years.
Thanks for your intelligent questions, Scott.
PE do you use? 12 month trailing or future?
I use P/E10. That is the price of the index over the average of the last 10 years of earnings. That is the valuation metric favored by Yale Professor Robert Shiller and Benjamin Graham (Buffett’s mentor) before him.
Using PE would also mean that you might have gotten out of the market during the great bull run and missed that dramatic increase.
I went to a zero stock allocation in 1996. I missed the huge gains of 1997, 1998, and 1999. I have been in TIPS and IBonds paying 3.5 percent real. I am ahead of the game today. I don’t say that to brag. I say it because it illustrates how paying attention to valuations works. Paying attention to valuations rarely pays off in the short run. It is only in the long run that stock returns become predictable. At high valuations, stocks can do well for one or two or three years but not for 10 or 15 years.
“So valuation is definitely a component of stock investing but shouldn’t be the only thing to look at…especially when you are talking about individual stocks. Growth stocks can have and support higher PEs than a stable value play. Dividend yield should also be accounted for as well.
I agree that my approach would not work well for those invested in individual stocks. Valuation-Informed Indexing is intended as a replacement for Buy-and-Hold, which I do not believe works well at all for the long-term investor. The idea is to retain the simplicity of Buy-and-Hold while greatly reducing the risk that comes from not adjusting your stock allocation in response to big valuation swings. Those who buy individual stocks can do better but it takes a lot of work and skill to pick stocks effectively.
If 14 is fair value that means at times we go under that though in the past decade have we spent much time under it?
It’s been a long time since we have been below 14 (except for a brief moment in February 2009). It is insanely high valuations that always lead to insanely low valuations (they are two sides of the same emotional investing coin). Since we went to the highest valuations we have ever seen in the late 1990s, we are likely working our way to the lowest valuations ever seen sometime in the next decade.
If we all paid attention to valuations, market prices would self-correct. Both overvaluation and undervaluation would become a logical impossibility. There would be no more bull markets and no more bear markets and far fewer economic crises. We could all obtain much higher returns at greatly reduced risk. I see this as Investor Heaven!
Rob
Investors go broke from a lack of research, no diversification and hanging on to losing stocks for way too long.
Invest in what you know says Mr. Buffet.
Other than that, what about transaction costs? I think those play a huuuuuge role in individual trading.