Investment Behavior

05/12/03 - What Motivates Investors?

By: Investor Solutions, Inc.

We are not as rational as we think we are. When it comes to money and investing, people do some pretty strange things. Ever wonder why we do the things we do with our portfolios? Well, there's a whole field of study that explains our sometimes-strange behavior. Where do you fit in?

Much of the economic theory available today is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process. This goes hand in hand with the efficient market hypothesis. In fact, researchers have uncovered evidence that rational behavior is not often the case. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision making process.

Prospect theory

It doesn't take a brain surgeon to know that people are risk averse and prefer a sure investment return rather than an uncertain one. We want to get paid for taking the extra risk. That's pretty reasonable.

Here's the strange part. Prospect theory suggests people react differently to equivalent situations depending on whether it's presented as a gain or a loss. Individuals get more stressed out by prospective losses than they are happy by equal gains. Sounds silly, but true. You'll never hear an investment advisor tell you she got flooded with calls because she reported, say, a $500,000 gain in a client's portfolio. But, you can bet that phone will ring when a similar report posts a $500,000 loss! A loss always appears larger than a gain of equal size. It's funny how when it goes deep into our pockets, the whole perspective changes.

How many times have you held onto a losing stock because you couldn't bring yourself to sell it at a loss? People end up taking more risks to avoid losses than to realize gains. Gamblers on a losing streak behave in a similar fashion, doubling up bets to try and recoup what they-ve already lost. By having the following misconception, "I know the stock price will bounce back, then I'll sell it", investors pile on more risk to avoid realizing a loss. If these seem like inconsistent attitudes toward risk, well, they are! What we find is people set a higher price on something they own than they would normally be prepared to pay.

An alternative to the loss aversion theory is that investors might choose to hold their losers and sell their winners because they believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing the action by investing in stocks or funds that receive the most attention. In support of this notion, research shows that money flows in more rapidly to mutual funds that have performed extremely well than flows out of from funds that have performed poorly.

Regret theory

"Fear of regret" or "regret theory" deals with the emotional reaction people experience after making what they think is an error of judgment. Investors become emotionally affected by their original purchase price of a stock when going to sell it.

So, they avoid selling the stock in order to avoid the regret of having made a bad investment and the embarrassment of reporting loss. We all hate to be wrong, don't we?

What investors should really ask themselves when faced with a similar situation is, "What are the consequences of repeating the same mistake and if this security was already liquid, would I invest in it again?" Chances are that you would not.

Regret theory also holds true for investors who did not buy a stock they had previously considered and which subsequently went up in value. By following the conventional wisdom, some investors avoid the possibility of feeling regret by rationalizing their decision with 'everyone else was doing it". Although it does not make much sense, some feel it's much less embarrassing when you lose money on a popular stock that half the world owns like the CMGI's, AOL's and Yahoo's of the world. On the flip side, losing on an unknown or unpopular stock is a little harder to swallow.

Mental Accounting

Humans have a tendency to place particular events into mental compartments.

Here's an example: You decide to catch a show at the local theater that costs $20 per ticket. When you get there you realize you've lost a $20 bill. Do you pay the $20 for the ticket? Roughly 88% of the people would do so.

The same problem with a slightly different perspective results in totally different numbers. Let's say you already paid for the $20 ticket in advance. When you arrive at the door, you realize you left your ticket at home and that the only way to get in is to buy another ticket. Would you purchase another ticket now? This time only 40% of the respondents would buy another. Either way you're still out $40. Different scenarios, same amount of money, different mental compartments. Pretty silly, huh?

Another example of mental accounting is best illustrated by a common scenario these days, the hesitation to sell an investment that once had a monstrous gain and now has a modest gain. During the economic boom and bull market of recent years, people got accustomed to healthy, albeit paper, gains. Now that the market correction has deflated their net worth, they're more hesitant to sell at the smaller profit margin. They've created mental compartments of the gains they once had, and may one day recoup.

Anchoring

In the absence of better information, investors assume that the market price is the correct price. People tend to place too much credence in recent market events and mistakenly extrapolate recent trends that often differ from historical, long-term averages and probabilities.

During bull markets, investment decisions are often influenced by price "anchors" that are based on their closeness to previous prices. This makes the more distant returns of the past irrelevant in their decision to buy.

Take for example the S&P 500 whose performance for 3 years ended 1999 was an aberration of its historical performance. Yet, up until last year, people felt the only direction for it was up and kept piling more money in it. They anchored themselves on the recent performance without taking into account true historical returns.

The compound return for the S&P500 from 1926 to 1999 was 11.35%. The returns for 1995, 1996, 1997, 1998, and 1999 were 37.43, 23.07, 33.37, 28.58, and 21.03 respectively. S&P 500 had a --9.1% return for 2000.

Over/Under Reaction

Investors get optimistic as the market goes up, assuming the market will continue to go up, but become pessimistic in market downturns. Placing too much importance on recent news while ignoring historical data may result in market over- or under-reaction. The outcome is that prices fall too much with bad news and rise too much with good news.

At the peak of optimism, investor greed moves stocks beyond their intrinsic value. When did it become a rational decision to invest in a stock with a price to earnings (P/E) ratio of 1,000 (think dot com last year)! You cannot project earnings using infinite numbers. Perhaps a better term is P/L (perpetual loss ratio)!

Extreme cases of this situation may lead to market panics and crashes.

Overconfidence

People generally rate themselves as being above average in their abilities. They also overestimate the precision of their knowledge and their knowledge relative to others. Many investors believe that they can consistently time the market. In reality, there is an overwhelming amount of evidence that proves otherwise. The result is that most investors trade too much and those trading costs cut into their profits. For the long term, this has proven to be a losing strategy.

Counterview

The theories of behavioral finance directly conflict with the "standard finance" academics. Each camp attempts to explain the behavior of investors and what the implications of that behavior are for the stock market.

Perhaps the most obvious argument against behavioral finance theories is the "efficient market hypothesis" associated with Eugene Fama (Univ. Chicago) & Ken French (MIT). They argue that markets are efficient and that investors act in a rational way while in pursuit of their best interests. The efficient market hypothesis states that market prices efficiently incorporate all of the information available. Furthermore, anomalies like those dealt with in behavioral finance are just chance results and most long-term return anomalies disappear. There is not enough evidence to suggest that market efficiency should be abandoned. Perhaps Peter Bernstein said it best when he stated, "while it is important to understand that the market doesn't work the way classical models think- there is a lot of evidence of herding, the behavioral finance concept of investors irrationally following the same course of action -- but I don't know what you can do with that information to manage money. I remain unconvinced anyone is consistently making money out of it."

Conclusion

Behavioral finance certainly reflects some of the attitudes embedded in the investment system. "Behavioralists" will argue that investors often behave irrationally, which produce inefficient markets and mis-priced securities leaving a perfect opportunity to make money. That may be true for an instant. But, consistently uncovering these inefficiencies is a challenge in itself. It's highly doubtful that these behavioral finance theories can be used to effectively and economically manage your money.

Investors are their own worst enemies. Trying to outguess the market does not pay off over the long run. In fact it often results in quirky, irrational behavior, not to mention a dent in your wealth. Implementing a well-thought out strategy and then sticking to it may help you avoid many of the common investing mistakes people often make.

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