To feel excited when our portfolios increase in value and to experience fear when they decrease in value is perfectly normal and acceptable. However, these emotions become problematic once we start making decisions based on emotional entanglements that limit our ability to reason. To prevent ourselves from making such decisions, we first have to recognize our capacity to make poor financial decisions based on emotions in order to then recognize the emotions that drive them. In response, we can then take a more defensive stance that could potentially limit the risk of damaging our long-term financial security.
First, identify the enemy. We are our own worst enemies when it comes to managing our finances. When we understand how we tend to respond in certain circumstances, we can develop a plan to defend our finances from our emotional responses the next time we have similar experiences.
Second, recognize the challenges. You are likely very familiar with the excitement of financial gain and the fear of financial loss; however, you probably are not aware of how your brain’s wiring influences those responses. Investing affects us not only emotionally and psychologically but physiologically as well.
Neuroeconomics, the study of neuroscience, economics, and psychology, shows that any thoughts or decisions about financial profit use the same part of our brains that is hardwired to pursue pleasure. In contrast, the experience of financial loss is processed by the part of our brain that triggers a full reaction to pain or danger and causes fight or flight. Your brain is so sensitive in such situations that it even responds differently if you are planning for short-term monetary rewards than if you are planning for long-term ones (Technology Review, May 2005, Huang). In other words, your responses to investment plans and outcomes are very complex.
Once you recognize these responses in your own behavior patterns, you will have a better chance of achieving financial security. Recognizing them will also help you keep your emotions in check the next time we face a bear market, which is a part of every five year cycle. Jason Zweig, a columnist for the Wall Street Journal and editor of the revised edition of Benjamin Graham’s The Intelligent Investor (2003), expands on this mental response with an analogy: “There is not much difference in the brain between having a rattlesnake slither across your living room carpet and having some stock you own go down by 40% or 50%.” Recognizing that you may not have much of a chance battling a rattlesnake barehanded, you might resort to a flight response because you merely hope to get out alive. Not surprisingly, you may feel similarly in response to a disastrous drop in the value of your investments.
Additional psychological forces include personal biases, emotions, and past experiences, all of which can influence even experienced investors. Some psychological forces are quite obvious while others are very subtle. Nevertheless, there are psychological pitfalls you can be aware of and straightforward advice you can use to help mitigate their impact. A few of these include a fear of regret, myopic risk aversion, overconfidence, and the “herd mentality.”
Fear of Regret
Investors who are affected by fears of regret put off financial decisions because they hope to get even more information and feel even more confident before having to make decisions. Consequently, these investors sometimes hold on to losing stocks for too long or sell winning stocks too quickly. They hold on to losing stocks rather than accept a loss for two reasons: they hope the investments will eventually make gains, and they feel as though selling them confirms that they had made a mistake by buying them in the first place. Those with winning stocks sell too quickly because they want to do so before the stocks start to lose value – they hope to “quit while they are ahead.” If you tend to worry that you will regret similar investment decisions, listen to Deena Katz, a chairman for Evensky and Katz Wealth Management: “My mom always said, if you’re going to do it, don’t worry; if you’re going to worry, don’t do it. You’ve already made the commitment to be where you are invested . . . You’re there. And unless you need to get out, you’re committed” (Money, May 2008).
Myopic Risk Aversion
Myopic risk aversion certainly sounds like something you would hear in an eye doctor’s office, and it actually does relate to a type of “vision.” People exhibiting myopic risk aversion cannot focus on long-term gains because they are too fixated on short-term losses. Such a focus makes sense psychologically, but it could be an exceptionally dangerous pitfall for investors right now. Even those who are usually confident about their long-term investment goals may become anxious about recent fluctuations in the market and might end up losing money unnecessarily because they can only focus nearsightedly on the immediate future. To avoid this pitfall Robert Arnott, the founder and chairman of Research Affiliates (a developer of investment products) suggests that rather than ask yourself what you can do to make money in the next three months you should ask yourself, “What would I want my portfolio to look like over the next 30 years?” (Money, May 2008).
Overconfidence
Overconfidence is somewhat the opposite of myopic risk aversion. Recent research indicates that many investors, especially men, overestimate their own abilities as well as the accuracy of the information they gather prior to making financial decisions. As a result, overconfident investors tend to overtrade, which usually leads to lower returns. An article in the February 2007 issue of Inc. explains that “overconfidence is one of the worst failings an investor can have.” Despite the temptation to guess the future or try to control what will happen (both of which are forms of overconfidence), investors have to admit that neither is possible to do, no matter how confident they may feel in their abilities.
Herd Mentality
As Niccolo Machiavelli explained, “[People] nearly always follow the tracks made by others.” Such behavior causes us to go along with the collective wisdom and tastes of the larger masses in a variety of situations. Clothing fashions, community circles, automobile selection, and even investing habits reflect that humans are social creatures who are very likely to “follow the herd.” When it comes to investing, social environments and the media heavily influence people into jumping blindly on the investment bandwagon without employing sound reasoning and research. Therefore, unfortunately, investors will unwittingly follow the herd even if the herd’s direction is to the detriment of the investors’ personal and financial goals and even if doing so goes against their individual reasoning abilities.
The Madoff Scandal illustrates this tendency perfectly. Many people, who had long been successful investors, forgot about the importance of research, prudence, and diversification in large part because they followed peers who were investing with Bernard Madoff. Recognizing the role societal influences played, David Zarolli reported in a December 2008 story for NPR’s “All Things Considered” that “it was prestigious to invest with him.” In fact, people even joined his country club in Florida merely to meet him and get a personal invitation to invest with him. In addition to a prestige factor, behavioral finance experts explore other key reasons we are willing to follow the herd. The Market Analysis, Research, and Education group, a unit of Fidelity Management’s research company, explains that an “investor may follow the herd because he or she feels an intuitive sense of conformity, whereby aligning oneself with the consensus of a large group going in the same direction is more comfortable than making an alternative, less-popular choice.” If we follow the direction of a larger group of investors, we can act based on the assumption that many others must have access to superior knowledge. And how could so many others be wrong? Conversely, we tend to believe that the groups that we are part of are naturally more likely to be right. (Otherwise, we would not experience the sense of affinity that defines those groups to begin with.)
Including the original Ponzi Scheme, there are quite a few historical examples when a number of individuals have fallen prey to the herd mentality. One, Tulip Mania, caused wealthy Dutch investors to spend obscene amounts of money on tulip bulbs or on shares of bulbs. Some even went so far as to trade houses so they could invest in one or two tulip bulbs! Such examples are evidence of the irrational behavior humans are capable of exhibiting, and we seem to be especially vulnerable when we are following others.
An investment trend in the late 1990s also demonstrates a similar but complicated example of herd mentality. During the emergence of the “New Economy,” Warren Buffet was ridiculed for his arcane investment theory because others believed that the New Economy marked a period when globalization and the acceleration of developments in information technology began to change economic trends. The mainstream media extolled the possibilities offered by this New Economy. As early as June 27, 1994, John Huey of Fortune wrote, “The advent of the new economy is unequivocably [sic] good news for the U.S., which holds a wide lead over the rest of the world in developing, applying – and now exporting – technology.” When referring to the New Economy, a September 27, 1999 Time magazine article titled “Get Rich.com” asked, “If you're an entrepreneur, why waste your time in the old world, worrying about manufacturing things and dealing with unions and OSHA inspections, when you can put your company online in three months?” If only people had listened more to Warren Buffet and less to the media’s promotion of the New Economy.
One way to better appreciate the investment trend in the late 1990s is to study the relationship between net sales of equity mutual funds. During the first quarter of 2000, as seen at Point 1 in the graph on the next page, the stock market was coming off of five straight years of double digit gains, and many of those gains were led by technology stocks. Between 1995 and 1999, the S&P 500 advanced 251% while the tech-heavy Nasdaq advanced 457%. In January 2000, at the peak of this multi-year rally, a record number of media headlines alluded to a “bull market.” Then, as it turned out, the first quarter of 2000 ended up being the peak of the market: over the next three years, the Nasdaq plummeted 67%, which meant devastating losses for those investors who had concentrated heavily on technology stocks. Those who had followed the herd and entered the market during the later stretches of the metaphorical stampede likely suffered the greatest losses because they had joined the herd at the riskiest time.
Joining the herd as it ventures into new territory and takes new risks can be just as costly as joining it too late because those who follow the herd to supposed safety allow themselves to be led out of the stock market at the wrong times, too. In the final quarter of 2002, for example, after nearly three consecutive calendar years of downturns in the stock market, the number of headlines that suggested the possibility of a continuing bear market rose significantly. In response, investors became increasingly fearful and anxious before finally reaching the point of capitulation. Between June and October 2002 (Point 2) (open full pdf document at the end of this post to view the graph), the S&P 500 declined 16% and the Nasdaq declined 18% – in just five months. Investors pulled a monthly average of 13 billion out of equity mutual funds compared to the average monthly inflow of 19 billion that had continued during the previous five months. As the attached graph shows, people were buying when it would have been a better time to sell (Points 1 and 3) and were selling when it would have been better to buy (Point 2). It is worth noting that some investors did act individually and may not have focused only on long-term investments. Regardless, both types of investors lost money because of poor decisions and bad timing.
Just as these investors retreated from equities during the second half of 2002, many also shifted their money into money market funds because of their relative safety. In November 2002, a record of 136 billion in net sales flowed into these money market funds suggesting that many investors were turning away from stocks near the bottom of a three-year bear market. In fact, by the end of 2002, the level of ownership in money market funds reached an all-time high of nearly 35% of all outstanding United States mutual fund assets. At roughly the same time, the S&P 500 began a sharp comeback: it rose 29% in 2003, which helped jumpstart a five-year bull market rally. For those who had recently decided to follow the herd by concentrating their portfolios into cash-like investments, the move may have been very costly.
If you have ever been misguided because you followed the herd, do not be too hard on yourself. Stephen Greenspan, the author of the book Annals of Gullibility, accounted in a recent Wall Street Journal article how even he, someone knowledgeable about what can happen as a result of trust and/or ignorance, lost some of the savings he had accumulated from his book sales to Bernard Madoff. Greenspan explains in the article how “some risks are more hidden and, thus, trickier to recognize than others” (2009). Investors of all experience levels need to always be cognizant of the aspects of investing that influence their financial decisions.
- James E Wilson, CFP®
This is the fourth chapter to a seven part series on the Barriers to Financial Security. To download a full copy of the whitepaper, click here
