If asked, most people would probably say they are rational individuals who make wise decisions. Indeed, logical thinking and prudent behavior are the norm for the majority of people in most instances. Unfortunately, when it comes to money management, people who are otherwise rational often tend to act irrationally, and this tendency is quite pervasive. Regardless of our age, level of education, or occupation, from time to time, most of us make illogical decisions when it comes to our finances.
For example, how many times have you heard of an investor who held onto a losing investment even when the prospects for recovery seemed slim at best? What about investors who sell their winning investments prematurely, only to see the value of the securities continue to rise? And why are some people more inclined to splurge with money that they may have received as a gift, bonus, or inheritance while being more frugal with money that’s been earned? And what of those who succumb to the latest investment hype - all too eager to jump on the bandwagon of the current hot trend? Indeed, most of us recall the late 1990s and the growth of the dot.com bubble as more and more investors scrambled to participate in what was being called the “new economy.” Unfortunately, the bubble finally burst in 2000-2001 effectively erasing the wealth of many.
While conventional financial theory has long held that investors are logical individuals who seek to maximize investment returns through prudent and wise decision-making, in reality, research has found that investment decisions are often guided by emotion or intuition. This realization has led to the growth of Behavioral Finance: a field of study that seeks to explain the causes of irrational and often detrimental investment decision-making.
One of the key tenets of Behavioral Finance is that as humans, we are prone to biases or “mental shortcuts” that influence our decision-making. These biases often cause us to by-pass rational thinking and instead fall back on preconceived notions or intuition.
While there are numerous biases that influence how we behave, one that affects the logical decision-making of many is “loss-aversion.” Generally speaking, most people seem to have a natural tendency to despise and avoid losses. In fact, most tend to view losses more negatively than they will view positively a similar sized gain. As it pertains to investing, loss aversion may cause an investor to hold onto an underperforming security because if he or she were to sell it, the investor would have to face the reality of sustaining the loss and the potential anxiety that may ensue. On the flip side, loss aversion may explain why some investors may be quick to cash out of an investment that seems quite promising. To some, it may be better to lock in a gain of any amount than to suffer a potential loss in the future.
To avoid the pitfalls that may come from loss aversion, we believe that investors have the greatest chance for financial success when they remain unemotional with respect to their investments. Rather than reacting to short-term market events, we believe that investors are best served when they make strategic decisions that are consistent with their overall investment goals and objectives.
While loss aversion can help explain instances of poor decision-making, “mental accounting” helps to explain why some people illogically segregate their money based on its origin, or the anticipated use of the funds.
According to mental accounting theory, people often put more or less value on different pools of money based upon its source. Earned money, it seems, is valued more greatly than money that was “found,” as individuals seem to have a tendency to protect, and use more wisely, money that they’ve earned vs. money that was received otherwise. Logically, to maximize their overall financial well-being, most would be wise to treat all money as equal in value, regardless of its origin. After all, a dollar earned or a dollar gifted carries the same utility, while contributing equally to one’s bottom line.
Another example of irrational behavior that may stem from mental accounting is making additional mortgage payments while carrying other debt at higher interest rates. While a desire to own one’s home free and clear may motivate some to pay down a mortgage more quickly, the value placed on a debt-free home while carrying other debt at higher interest rates is illogical. Not only will paying higher interest rates cost more in the long run, but the interest paid on other types of debt may not be tax deductible as is typically the case with interest paid on mortgage loans.
While we often think of individuals as acting irrationally, “herd behavior” helps to explain why entire groups of people may act unreasonably. According to herd theory, individuals have the tendency to assume the attitudes and behaviors of a larger group, whereas when acting alone, they may behave quite differently.
So why do otherwise rational people fall prey to the attitudes, beliefs and behaviors of a larger crowd? Part of the explanation may lie in the natural desire of many to conform to the group, thereby making one’s self more acceptable to that group. Another reason may lie in a belief that the group as a whole must be smarter than any one individual. There may be a fear that if one doesn’t follow the actions or behaviors of the crowd, one could “miss out.” This could logically explain why so many investors got caught up in the tech stock craze of the 1990’s, or more recently, the initial public offering of Facebook stock in the spring of 2012.
There’s little doubt that when it comes to their finances, people often allow their emotions, intuitions or biases to overrule logical thought. In doing so, they may be making decisions that on the surface seem “right,” but when examined more closely, are actually detrimental to their well-being.
The first step in avoiding the temptation to follow emotion is, perhaps, the recognition of such as a human tendency. If we can understand how and when we might be prone to act irrationally, we may be better equipped to avoid the temptation to act rashly, and instead, apply critical and reasoned thinking to our decisions, actions and behaviors.
While awareness of our tendencies may serve as a first line of defense against falling victim to negative behaviors, we believe that a collaborative relationship and on-going communication with our clients is critical to their success. Working together, we can help you avoid the distractions that may result in emotional decision-making, while helping you make the objective decisions necessary to help you reach your long-term goals.
1. Shlomo Benartzi, Ph.D., Behavioral Finance in Action: Psychological challenges in the financial advisor/client relationship, and strategies to solve them, Allianz Global Investors, http://befi.allianzgi.com/en/Topics/Documents/behavioral-finance-in-action-white-paper.pdf
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