2007-03-02 / Columnists

Focus On Financial Affairs

Behavioral Finance: Explaining Why Investors Act The Way They Do

When a stock declines in value, why do some investors fixate on "breaking even" - or getting back to their purchase price - rather than cut their losses through a sale?

What causes many taxpayers to treat a refund as a "windfall" even though it's essentially money they've overpaid to the IRS?

In a perfect world, the answers to these questions would be easy since people are expected to be inherently rational when it comes to their financial best interest.

But, as the emerging field of Behavioral Finance asserts, this is not how human nature works.

Like many theories that fly in the face of conventional wisdom, Behavioral Finance got its start in academia. University of Chicago professor Richard Thaler started to research the topic in the early 1970s and is regarded as one of its pioneers.

Nearly three decades later, Princeton University's Daniel Kahneman won the Nobel Prize for his research on the subject. Despite its ivory tower pedigree, however, Behavioral Finance is not universally accepted.

Most of its naysayers adhere to the traditional Efficient Market Theory, which contends that there is perfect information in the stock market. Because everyone has the same information about a stock, the thinking goes, the price of a stock should reflect the knowledge and expectations of all investors.

The bottom line is that investors should not be able to "beat the market" since there is no way for them to know something about a stock that isn't already reflected in its price.

On the other hand, Behavioral Finance attempts to uncover repeated patterns of inconsistency in the way people make financial decisions. Sometimes these irrational behaviors can undermine an investor's long-term success. At a minimum, they arouse feelings of pain and anxiety that can make investing an unpleasant experience.

Here are three common tendencies - mental accounting, loss aversion, and overconfidence - that reduce investors' chances of reaching investment goals, regardless of income level or net worth.

Mental Accounting

Instead of looking at the big picture, people tend to mentally compartmentalize their assets into different "buckets," which they manage independently, and treat differently.

As a result, it's easy to lose sight of the fact that each category of money - regardless of source - contributes to overall wealth.

The tax refund is one example of mental accounting; buying on credit is another. Some believe that a dollar charged on plastic affects the bottom line less than making physical cash payments.

This explains why many spend recklessly with plastic only to watch their monthly debt obligations soar. And when it comes to diversifying their portfolios, many investors make decisions in pieces, not recognizing that even marginal decisions can affect the entire portfolio.

Loss Aversion

People hate to lose, especially when it comes to admitting they made an investment mistake. In fact, studies show that investors typically consider the loss of $1 two and one-half times as painful as the pleasure received from gaining $1.

This probably explains why many investors gravitate toward the low-yielding "safe" returns of money market instruments even though they have a time horizon and financial goals that warrant a more aggressive strategy.

Another example occurred during the recent bear market when investors held on to stocks with dismal earning prospects.

Many believed that, if they didn't sell, the loss on paper would not become "real." In the process, these investors watched a significant portion of their net worth disappear waiting for their investments to reach price levels that never came.

Overconfidence

Many investors falsely believe that they are as good, or even better, at picking stocks than everyone else with access to the same information. Investors may fall into a similar pitfall when they attempt to time the market. Unfortunately, the financial media - who know that writing about one-of-a-kind stock pickers such as Peter Lynch sells magazines - often foster this fallacy.

In addition, most investors have short-term memories when it comes to their losses, which can lead to unrealistic expectations about their ability. Perhaps that's why people rarely discuss their investment failures at parties, and are often reluctant to seek professional financial advice.

Recognize yourself in one or more of the traits described above? You're not alone. These are just a few of the ways even the best-intentioned investors can veer off course.

For many investors, especially those who desire some more structure and discipline around their investment decision-making, this is where a qualified financial advisor can be invaluable.

Ideally, he or she understands the emotional side of investing and has the credentials to devise a comprehensive investment plan tailored toward your financial and personal objectives.

In conclusion, Behavioral Finance may not be an exact science, but it can help you better understand, and avoid succumbing to, human tendencies that have the potential to derail financial goals.

Editor's note: Stephen J. Levine is an independent financial advisor. For more information on this topic, readers can contact him at 257 Beach 126th Street, Belle Harbor, NY 11694 or (516) 295-1410.

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