In the wake of volatile markets this week, we thought it useful to revisit the concept of behavioral investing. No matter how much advisors stress the importance of taking prudent risk in the pursuit of long-term gain through rational asset allocation, many people let their emotions rule in the face of short-term turmoil.
In a recent piece, Cadaret, Grant in association with InvestmentNews deconstructed behavioral investing into six elements that are worth keeping in mind during uncertain times.* Understanding them can help advisors better help their clients when they may need it most.
1. Loss Aversion. Research shows that to an individual, losing feels more than twice as bad as winning feels good. The average investor would need the prospect of realizing $225 for the same level of risk of losing $100. The implication is that however rational and well-meaning an investor may be when filling out a risk profile, their fear of loss may override. Just as in good times an investor may be irrational in the pursuit of gain, so he or she may impulsively pull back at exactly the wrong time.
2. Anchoring. Anyone trying to sell a house in a buyer’s market may have experienced anchoring. It’s the tendency to focus on one piece of information – in this case the property’s purchase price – in evaluating a reasonable selling price. Often investors “anchor” on a fixed price of a security – what they paid for it or what they somehow think it’s worth now – before parting with it. This emotional attachment can get in the way of rational action, or inaction.
3. Familiarity Bias. Part of our survival instinct is to evaluate new situations through the lens of our experiences. Our minds tend to seek out similarities to past events to come up with a conclusion or assessment of a current situation, no matter how new and unrelated it may be to what we’ve experienced in the past. So, familiarity with domestic equities or mature industries may lead an investor to overweight them in a portfolio to the exclusion of less familiar asset classes or sectors, and possibly to the detriment of overall investment performance or risk management.
4. Mental Accounting. When it comes to money, we tend to compartmentalize. We may try to save a couple of dollars on a weekday lunch but think nothing of spending twenty times that while on vacation. Through mental accounting, we tend to view the same dollar amount differently based on what we’ve mentally earmarked it for. Retirement savings, for example, may be a mental compartment in which a dollar is more sacrosanct than in a self-directed trading account. Understanding these compartments, and making sure each has an appropriate share of total worth, can help a client buy, spend, save and invest more wisely.
5. Gambler’s Fallacy. This behavior tends to view a coincidental series of events as predictive. If a coin toss comes up heads six times in a row, it doesn’t mean it’s less likely to be heads than tails on the seventh. But the fallacy discounts the logic because we humans tend to see patterns in random events. So, if a stock gets repeatedly hammered, the flawed thinking says it’s got nowhere to go but up.
6. Herd Mentality. Market bubbles (and troughs) are a telling result of herd mentality. What starts as reasonable optimism sometimes takes on a life of its own as the herd adds more and more likeminded overenthusiastic investors to its ranks. Herds can also head in the opposite direction when reasoned pessimism turns to outright panic. Keeping excessive enthusiasm or dread in check can be the most valuable service an advisor provides to a client. In a recent study, Vanguard pegged the value of being an “emotional circuit-breaker” at as much as 150 basis points to a client’s portfolio over time.**
* Behavioral finance: Six principles that fuel your clients’ fears, Cadaret, Grant in partnership with InvestmentNews Research
** Putting a value on your value: Quantifying Vanguard Advisor’s Alpha®, Vanguard Research, September 2016