The Human Side of Investing : January 13, 2016
A recent conversation with a client got me thinking about the important relationship between psychology and investing. Should a short-term decline in stocks bother us when, in the long run, short-term ups and downs really have little significance? Well, no matter whether or not it should bother us, it does. After all, the S&P 500 just had its worst-ever start to a year, dropping 6% in the first week of 2016 as fears of slowing growth in China came back into focus. Feeling unsettled is a normal human response. Fortunately, there are a number of insights from psychology that can help us put these emotions in perspective and our focus back on our long term investment plan.
You’ll often hear Gabor and me talk about behavioral finance, which is an academic discipline utilizing insights from psychology to explain people’s economic and investing decisions. It’s the human side of investing, and it’s as important as the technical side. In particular, it uncovers a number of cognitive biases that we have when investing, and by understanding and recognizing these biases investors are better able to correct and avoid financial misbehaviors. As with other areas of life, an awareness of our emotions can help us cope better, even under the most adverse of circumstances.
There a two biases that tend to cause the most damage to our financial well-being according to Richard Thaler, professor of behavioral finance at University of Chicago. The first is loss aversion. Losses have about twice the emotional impact of an equivalent gain. Think about it; finding $100 cash feels pretty good, but losing $100 feels absolutely miserable. Fear of losses and a tendency toward short-term thinking (a third bias) often inhibit appropriate risk-taking, and tend to dominate people’s thinking during periods like the start of this year.
The second bias that gets us in trouble is overconfidence. Studies show that most people think they are above-average in things they do, and this is especially true with investing. As a result, investors have a fundamental tendency to trade too much and diversify too little. Overconfidence can also lead people to invest during what appears to be a bubble, thinking they will just get out faster than others, and to sell during periods of decline like the present, thinking they will get back in just before the market goes up. Research, however, shows that the more individuals trade and try to time the market, the lower their performance especially over time.
So, how can we manage these self-destructive biases? According to Thaler, the most successful way of dealing with such biases is by committing ourselves to how we will handle the situation in advance and having a plan. He also recommends to avoid a day-to-day focus on financial news, which tends to stir up these biases and inflict damage to one’s financial and emotional well-being. Instead, we suggest to leave the day-to-day market-watching to us, and stay focused on your long term plan that is designed to anticipate not only stock market volatility, but virtually any other adverse circumstance that is beyond your control.
By the way, for those interested in behavioral finance or psychology generally, a book we highly recommend is “Thinking, Fast and Slow” by Daniel Kahneman, who is often considered the father of behavioral finance.