May 23, 2018. By J.D. Wolfsberg:
Traditional Finance Theory is based on the presumption that investors are risk averse, collect all relevant information, weigh each piece of information appropriately, and arrive at the sound indisputable answer to maximize their utility. In other words, Traditional Finance Theory assumes that we behave as computers. Behavioral finance, on the other hand, introduces concepts that contradict how Traditional Finance says we should behave. It assumes that we act…of all things…like human beings.
I had a football coach that once asked me, “Do you hate losing more, or do you love winning more?” At the time, I couldn’t figure out why he was asking me that question. After giving it a great deal of honest thought, I admitted to myself that I had a harder time shrugging off a loss than I had a good time celebrating a win; I hated losing more than I loved winning. Behavioral Finance indicates that investor behavior is no different.
Behavioral Finance suggests that investors may practice loss aversion rather than risk aversion. At times, the investor shows risk averse behavior when presented with gains, and risk seeking behavior when presented with losses. As absurd as it may sound, the theory has found that investors will actually take on more risk in order to try and avoid losses. This could lead to investors holding on to securities that have deteriorated for too long and selling other securities to realize gains too soon. The pain of realizing losses causes investors to ignore fundamentals, and to hold and sell securities with solely the fear of recognizing losses in mind. Behavioral Finance also offers a take on the contribution of emotions to market bubbles and crashes. During market bubbles, investors may realize that they are in a bubble and are buying an overpriced asset. Fundamental rational behavior would steer someone away from investing in such an asset. However, the investor does not want to regret or “miss out” on the returns that may be generated until the bubble pops. Crashes result from similar behavior, and investors will panic-sell out of the market in an attempt not to be the last one out.
The best way to mitigate the negative implications of behavioral finance is to simply take a step back and address their presence, realizing that there are emotional biases infiltrating the world of investing. Sticking to the long term plan and avoiding the emotional urges to shift in times of volatility will pay off for an investor in the long run. An investment advisor can help an investor not only with formulating the long-term investment plan, but also by remaining objective at times where emotions attempt to get in the driver’s seat.