It’s Halloween season! That time of year when mysterious creatures arrive at my door dressed in all types of fascinating costumes demanding candy. Halloween is one of my favorites traditions. I camp out in front of the house with a space heater and a crock of chili. I dispatch candy to the walking dead and may even hand out an adult beverages to a parent or two. Since it’s an election year, I’ll sneak political literature into the goody bags of these unsuspecting swing-voter goblins. While a political bumper sticker may offend some, it’s way better than the toothbrush my dentist neighbor gives out.
It’s all fun and games until the scary clown shows up. Halloween or no Halloween, my wife is not fond of clowns (the ones with the painted faces and red hair bushy hair, not the politicians). Coulrophobia is an abnormal fear of clowns. Ironically, the etymology of the word “coulrophobia” is unknown, but fairly recent. The word originated in the late 1980s, proliferated via the Internet in the ’90s, and is now the go to word for fear of clowns. Ironically, use of the term “behavioral finance” has taken a similar path.
This field of study is rapidly growing. Every trade magazine or symposium I attend will dedicate significant resources toward the subject. Quick summary: Behavioral finance argues that people are not nearly as rational as traditional finance theory makes out. Traditional finance employs theories with a heavy emphasis on mathematical equations. Unfortunately, the average investor makes decisions on emotion rather than mathematics. Behavioral finance is just beginning to understand why.
Behavioral finance is a discipline that attempts to explain how mental mistakes and emotions of investors influence their decision-making process. Behavioral finance integrates the fields of psychology, sociology and other behavioral sciences to explain individual behavior, group behavior, and is even used to predict financial markets. Understanding investor behavior may make you better investors and may help remove that goblin of emotion from your investment decisions.
Let’s get started with prospect theory. Prospect theory suggests that individuals do not always act rationally. Really? In simple terms, you have biases.
Below is a list, not exhaustive, of some investor biases.
Representativeness bias: labeling an investment as good or bad. For example, bonds have been labeled a safe investment. But bonds will perform poorly in a rising interest-rate environment.
Regret or loss aversion bias: an emotion of regret after an investment turns south. Aversion bias may lead to unwillingness to sell a bad investment.
Disposition effect: a bias to sell winners too early and hold on to losers for too long.
Familiarity bias: a bias to hold local companies that you know. For example, some investors may only hold U.S. companies, ignoring the positive effects of diversification from other asset classes.
Anchoring bias: a bias that holds onto a certain belief and uses a subjective reference for making future judgments. For example, investors may use the great recession of 2008 as an unpleasant anchoring experience and therefore will never hold stocks in their portfolio ever again.
Self-attribution bias: This bias is my favorite, and I witness it in practice all the time. With self-attribution bias, the investor takes personal responsibility for good results and will blame others or external forces when they have bad results.
Others: trend chasing bias, disposition effect, hindsight bias and confirmation bias.
Behavior finance tends to label investors as either overconfident investors or status quo investors. As you would imagine, overconfident investors have a tendency to overestimate their own skills. Whereas status quo investors suffer from inertia, procrastination or inattention towards details.
Your personality type also has an impact. For example, if you are an extravert, you are outgoing and may accept more risk in order to satisfy your need for thrill or excitement. Conscientious personality types are very organized and may delay instant gratification and focus on long-term investments. Intellectual personality types are very creative, curious, and open to new ideas. These folks may search for new adventures in investing.
Unfortunately, this field doesn’t tell people how to be successful in the market. It just shows that psychology has an impact. Behavioral finance offers no investment miracles, but perhaps it can help you be watchful of your behavior and, in turn, avoid costly mistakes.
This article originally ran in the Old Colony Memorial and various www.wickedlocal.com sites.