Volatile Markets and Human Behavior

| January 31, 2012 | 0 Comments

Regret is a very complex emotion, but it is also one of the central emotions that drive our investing behavior. I was pondering the concept of regret the other day and thought I would share some of our thinking on the topic, to help you frame your own investment decisions.

Generally, when people think about investing, they are thinking about the stock market, Wall Street, CNBC and lately, roller coasters. There may even be visions of becoming Rich Uncle Pennybags* as you parlay your monthly 401k contributions into a vast investment empire.

For better or worse, much of investing today has more to do with our emotional responses to frequent mental stimuli. That’s one of the reasons that watching all day ‘investment’ channels like CNBC, Bloomberg or Fox Business Channel is such a bad idea. Even reading the Wall Street Journal daily can be hazardous to your wealth. Why? Because media companies, especially broadcast media, and even the paper you are reading right now, work very hard to develop emotional responses in their audience. These emotional responses keep you coming back for more and will trump rational thought, often at the moment when sound judgment is most important.

Human beings are perhaps the most rational, thoughtful animals on the planet. And yet we are still genetically hardwired with some very deep emotional responses to events and stimuli. These mental short-cuts served us very well as cavemen (e.g.: “watch out for that snake”) but, in the words of Chris Davis, manager of the Selected American Shares (SLASX) mutual fund, “They make us a complete patsy when it comes to investing.” Some of the better known biases in investing include:

  • Overconfidence, when investors think they have better information or insight than everyone else. For example, 80 percentage of drivers think they are above average, which is obviously impossible.
  • Mental Accounting, when the brain separates things like winning and losing investments, despite the need for these things to work together in a portfolio. This also occurs when investors consider gains from dividends differently than gains through appreciation, especially when the tax consequences of each are the same.
  • Familiarity, which in an investment setting refers to investing more heavily in assets with which we are more familiar and therefore more comfortable, whatever the individual merits might be.
  • Representativeness, in which investors extrapolate small pieces of information to make broad (and frequently inaccurate) conclusions.
  • Anchoring is another mental short-cut in which the brain starts with one reference point and then slowly incorporates new information to reach a (possibly different) conclusion. This process can take weeks or months.

The final bias I want to talk about is regret. We humans feel joy or pride when we make good (and profitable) decisions, and experience pain and regret when we make bad decisions. This can interfere with evaluating fundamentals and making sound judgments about the merits of a strategy or investment. Fear of missing out on a big run up can cause an investor to hold onto poor investments for too long. Similarly, the “snake bite” effect will cause investors to shun good investments that have lost money in the past.

Minimizing regret is one of the hardest things to do as an investor, but it is critical to positioning your portfolio so that you are comfortable (or at least minimally uncomfortable) in a volatile market like today. In order to minimize regret, an investor needs to understand when he or she will feel that emotion, such as comparing the potential losses of aggressive investments versus the discomfort caused by investing conservatively and not participating in a large gain.

In my next article, I will discuss one of the tools professionals use to do this.

* Rich Uncle Pennybags is better known today as Mr. Monopoly.

This column is prepared by Rick Brooks, CFA, CFP®.  Rick is Vice President for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management.  Rick can be reached at (858) 755-5166, or by email at brooks@bfadvisers.com. Rick and his family live in Mission Hills.


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