How Human Behavior Affects Investment DecisionsFebruary 6, 2018
- Emotions and mental biases can get in the way of rational decision-making.
- Behavioral investing suggests reasons why some of our actions might be counterproductive to our goals.
- Avoid the potential pitfalls these biases can create by making and sticking to a long-term plan.
The field of behavioral finance has outlined theories to explain why investors tend to make irrational decisions. We cover three of these widely known concepts:
With loss aversion, the pain of losses is more powerful than the pleasure of gains. This aversion to loss can contribute to panicked selling when the market drops or to the adoption of an overly conservative investment strategy to avoid short-term market fluctuations. These decisions may result in a portfolio that doesn’t keep pace with inflation.
Investors tend to place greater weight on what they’ve experienced most recently, using it as a guideline for what might happen next. Known as recency bias, this theory may help explain why millennials who came of age soon after the financial crisis have steered clear of stocks as they have started investing—even though they have exceptionally long time horizons when it comes to saving for retirement.
The idea with anchoring is that once you’re exposed to an initial fact or figure, you’ll continue to look back to that information as a reference point. Individuals influenced by anchoring tend to hold on to an investment that has lost value in hopes that the investment will go back up to the original purchase price, rather than focusing on fundamentals.
While there’s a natural human tendency to react emotionally to market swings, investors are encouraged to stick with a consistent, long-term investment strategy. This strategy can include techniques such as portfolio rebalancing, tactical allocation adjustments, or systematic investing—approaches that take market conditions into account without derailing a long-term plan.
Kahneman, D., Knetsch, J., & Thaler, R. (Winter, 1991). Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias. The Journal of Economic Perspectives, Vol. 5, No. 1, pp. 193-206.
Kahneman, D., & Tversky, A. (Sep. 27, 1974). Judgment under Uncertainty: Heuristics and Biases. Science, New Series, Vol. 185, No. 4157, pp. 1124-1131.
Thaler, R., & De Bondt, W. (Jul., 1985). Does the Stock Market Overreact? The Journal of Finance, Vol. 40, No. 3, pp. 793-805.