Brain Game: Some Thoughts on Behavioral Finance and Investing (4Q21 Mid-Quarter Newsletter)
Updated: Sep 27, 2022
December 15, 2021
Robert Gaan, CFP®
Back in early 2000, during the height of the dot-com boom, I remember scheduling a meeting with a client for a periodic portfolio review. We had assembled a diversified common stock portfolio based upon the client’s financial profile and risk tolerance, and I recall being very excited to schedule this meeting because the account had performed quite well during the prior year.
I met with the client, and we reviewed his account performance. To my surprise, he was unimpressed. It seems that the client had spoken to a relative who invested only in NASDAQ stocks. He reported that his relative’s portfolio was up over 80% in 1999. He asked if we could change the makeup of his investment portfolio to one made up of only NASDAQ positions. He commented that he “couldn’t afford” to miss out on the returns that these stocks were producing and suggested that perhaps it was time for WEIL to begin viewing investments through a more modern lens.
I reminded the client that we had spent quite a bit of time at the beginning of our working relationship identifying his long-term financial goals and we agreed that a diversified investment portfolio was appropriate given his financial facts and circumstances. I highlighted the nature of the stocks in his WEIL portfolio: quality companies in solid industries with seasoned management and prudent capital structures. I cautioned him about the inherent risks of concentrating his investments in exciting, yet unproven companies. After a thorough discussion, the client agreed to stick with our original investment strategy.
This proved to be the the right decision, as the NASDAQ index lost 39% of its value in 2000 and continued to fall significantly in 2001 and 2002. Looking back, I believe that our client nearly fell victim to a concept in behavioral finance known as “Recency Bias,” which is a common human tendency to place too much emphasis on recent events. This bias can cause investors to make short-term decisions that deviate from their long-term financial plans (and best interests).
According to Kaplan Financial, “Behavioral finance is the study of the effects of psychology on investors and the financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest, and make decisions based on personal biases instead of facts.”
Behavioral finance teaches that investors should strive to minimize the impact that emotions have on their financial decisions. This is hard to do because of the way the human brain is wired. Everyone knows that you are supposed to “buy low and sell high.” However, our emotions often push us to do the opposite. How many times have you heard someone say, “This stock is up 100% in the past week! You should buy some?” Well, no. Past performance should never be the sole driver of investment decisions. On the other hand, what about, “The market is down, you should sell your stocks before you lose more?” Again, no. If you own quality assets, you should probably hold and allow things to stabilize and recover. Better yet, if you have some cash, consider “buying low.”
In addition to Recency Bias, behavioral finance offers insight into other biases:
Fear of losing dramatically impacts the decision-making process when it comes to investing. According to the research, the average investor feels the pain of losses twice as much as they feel the pleasure of gains. This fear may cause investors to construct investment portfolios that are too conservative for their long-term financial goals.
For example, fear of stock market volatility may cause some investors to want to dramatically decrease the common stock allocation in their investment portfolio and increase their allocation to bonds. Conceptually, this makes sense given that bonds historically have been less volatile as an asset class than stocks. However, most economists today believe that inflation will significantly impact individuals’ spending power over the next 20 years (more than it has been during the past 20 years). Generally, bonds provide little to no protection against inflation and can lose value during periods of rising interest rates. Stocks, on the other hand, can provide opportunities for growth of principal over time, which can help offset the effects of inflation. Shifting one’s asset allocation to dramatically favor bonds in the current environment may significantly impact the purchasing power of those assets over time. In effect, by making the portfolio “safer,” the shift could actually be exposing the investor to greater risk.
Hindsight bias is the tendency to overestimate one's ability to have previously foreseen outcomes once those outcomes become known. It is also known as the “I-knew-it-all-along phenomenon.” Hindsight bias can negatively affect future decision-making, leading to overconfidence in one's ability to predict other future events, which may lead one to take unnecessary risks.
Hindsight bias was on display after the stock market crash of 2008 when a handful of market commentators pointed back to a set of events that seemed inconsequential before the crash and opined (with the benefit of hindsight) that they should have been seen as strong indications of a troubled market. They said (after the fact) that these indicators should have told everyone the financial disaster was coming. In reality, if the indicators had been that obvious in the moment, more people (including these commentators) would have seen them and taken appropriate actions to avert the disaster, or profit from it. While it is often the case that lessons can be learned in hindsight, it is also true that generals are often “fighting the last war” and investors are preoccupied with sidestepping “the last crisis.” We should all strive to be alert to fundamental structural problems that can lead to disruption, but we have to also understand that crises are very often the result of many factors, and pointing to a few with the benefit of hindsight can lead to undue caution or undue risk-taking in the future.
Anchoring occurs when investors allow purchase points or arbitrary price levels to influence their rebalancing decisions. Take the example of an investor who purchases a stock, only to see it lose value quickly after the purchase. Anchoring bias may cause the investor to want to hold the stock until it recovers to its original purchase price. The problem with anchors is that they do not necessarily reflect the intrinsic value of the underlying company. Perhaps the price decline was triggered by a fundamental change to the productivity or viability of the company or its industry. It might take a while for the share price of the stock to recover to its former levels, if it ever does. Anchoring bias can also cause an investor to ignore other opportunities in the market that may provide the investor with faster prospects for recovery.
Things You Can Control
When it comes to developing and deploying a financial plan, it is important to recognize that there are some things investors can control and some things that investors cannot control. Rather than trying to time the market or guess when interest rates are going to rise, perhaps one can increase their odds of achieving financial success by focusing on the things that can be controlled. Consider the following examples:
Implementing a systematic process for saving and investing
Clarifying financial goals and developing a long-term strategy to achieve those goals
Building diversified investment portfolios that fit your timeline and risk profile
Maintaining a journal to record financial decisions and detail the economic and market conditions that informed those decisions
Develop prudent and flexible strategies to adjust investments in retirement
Look for ways to be tax efficient
Use fundamental investment analysis to help measure intrinsic value and promote objectivity
Consult your financial advisor before making big financial decisions
We are all human. It is impossible to completely remove emotion from the equation when making financial and investment decisions. We should all expect to be tested periodically as unexpected or dramatic trends/events tempt us to make knee-jerk adjustments to our long-term financial plans. My advice to anyone seeking to achieve financial success: maintain perspective and take the long view.
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Investment in mutual funds is also subject to market risk, investment style risk, investment adviser risk, market sector risk, equity securities risk, and portfolio turnover risks. More information about these risks and other risks can be found in the funds’ prospectus. You may obtain a prospectus for CWC's mutual funds by calling us toll-free at 800.355.9345 or visiting www.cweil.com. The prospectus should be read carefully before investing. CWC's mutual funds are distributed by Rafferty Capital Markets, LLC—Garden City, NY 11530. Nothing herein should be construed as legal or tax advice. You should consult an attorney or tax professional regarding your specific legal or tax situation. Christopher Weil & Company, Inc. may be contacted at 800.355.9345 or email@example.com.
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