All behavior occurs for a reason, and your behavior as it relates to investing matters—a lot.
It's well documented that investment success isn't as much about skill as it is about behavior. Some investors, specifically those without a complete and comprehensive financial plan, make the same mistake over and over again—they buy high in the face of euphoria and sell low in the face of fear.
Euphoria, fear, and irrational behavior have a long record in the financial markets, beginning with the Tulip Mania of the 1600's. Then there was the South Sea Company bubble in the 1700's, the Railway Mania of the 1800's, the Florida land bubble of the 1920's, gold in the 1980's, the dot.com madness of the 1990's, and finally, the incredible housing obsession of the recent decade.
But why do investors do it over and over?
According to the theory of behavioral finance, we can't help it. There are a ton of studies and probably even more books that have been written on the subject of investor behavior. Riddled with themes like heuristics, framing, anomalies covering topics like prospect theory, mental accounting, and herd behavior, it all tries to provide scientific answers to the very unscientific question: Why do investors act so foolishly?
Here's a few of the most common culprits:
It's all in your head—half of it anyway.
Research suggests that a great deal of an investor's behavior rests on the cognitive functions of the right brain dominating the left brain. The right side of the brain—the emotional, primitive side—overrides the left or logical and analytical side of the brain when investors evaluate their decisions. Essentially, the emotional inputs are so strong that they routinely override any reasonable analysis when it comes to investing. There are several emotions that play into investment decision-making, but it's constructive to look at two of the most obvious: overconfidence and loss aversion.
Eighty percent of people think they are better than average—sound familiar?
That's overconfidence. A 1981 survey of automobile drivers in Sweden, pointed out by JP Morgan Asset Management, shows that 80 percent of the drivers surveyed said they were better-than-average drivers. I don't mean to point out the obvious here, but only 50 percent of the drivers can be better than average! This simple example of human nature goes a long way toward explaining a lot about why investors overestimate their ability to pick winning investments. Think you're a better-than-average investor? Studies show you are probably not.
A recent study by Dalbar, a financial services market research firm, shows that the annualized return of the S&P 500 over the previous 20 years was 8.4 percent. But the annualized return for the average equity investor was 1.9 percent for the same period. The reasons for the disparity are myriad, but include overconfident behavior like thinking a personal prediction is the best one, excessive trading, market timing, and selling winners too early combined with keeping the losers too long.
Six of one . . . isn't that the same as a half a dozen of the other?
It depends on you. It's a function of more emotion—pain versus pleasure—and it's called loss aversion. According to work by economist and Nobel Prize winner Daniel Kahneman, investors feel twice as much emotion over losing money as they do over making money. Said differently, investors feel more regret than pride when they weigh their investing decisions. A gain of 10 percent feels good, but the pain of a 10 percent loss feels twice as bad.
It's dangerous because investors lose context. Have you ever said to yourself, "I'm going to hold that stock until it gets back to even?" It happens all the time and when coupled with overconfidence, it really hurts performance.
Protecting yourself . . . from yourself.
Most people plan for market returns and they end up with the returns like those noted above. That's a shame, because if most investors who ended with up paltry returns simply removed emotion from the equation, they probably would have ended up with something much closer to the 8.9 percent S&P 500 return.
The solution? Formulate an investing strategy and stick to it. Base your investment decisions on either your immediate need for liquidity or on a long-term strategy within a complete and comprehensible financial plan, despite any fear or euphoria you may feel.
And if you don't have a plan, please get one.
David B. Armstrong CFA, is a Managing Director and co-founder of Monument Wealth Management in Alexandria VA, a full-service Private Wealth Planning and wealth management firm. Monument Wealth Management is an affiliate of LPL Financial, the independent broker-dealer. He has been named one of America's Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 & 2010). David and Monument Wealth Management can be followed on their blog at "Off The Wall," their Twitter account @MonumentWealth, and on their Facebook page Member FINRA/SIPC.
Disclosures: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results.
Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.