Reading Between The Lines The new science of behavioral finance can help investors understand why they make mistakes--and how to prevent the next one.
(MONEY Magazine) – Investing mistakes, like most things we do, have both immediate causes and more fundamental ones. Didn't do your homework on a stock that tanked soon after you bought it? Your more fundamental error may have been crediting previous lucky moves to skill, and thereby grossly overestimating your investing abilities. In fact, psychological factors lurk behind many, if not all, common investor slip-ups--so much so that a whole academic discipline called behavioral finance has developed to study them.
What behavioral finance researchers have found over the past 30 years or so is that the psychological processes that serve us well in many life circumstances often mislead us in the financial realm. Recognize the processes--so you can catch yourself before falling into these psychological traps--and you'll make better financial decisions, these experts say. Interested? Here's a thumbnail guide to investors' psyches:
--WE ALL PRACTICE "MENTAL ACCOUNTING." Whether or not you realize it, you probably have a tendency to categorize and treat money differently depending on where you got it, where you keep it or how you spend it. Sometimes that's good: Funds that have been earmarked for a child's college account, for instance, should be considered untouchable. Other times it's not so good: People tend to treat a windfall--whether it's a bonus, tax refund, gift or inheritance--more frivolously than they treat other money.
And sometimes, mental accounting simply defies logic. Research has shown, for example, that people will spend more money using a credit card than they will using cash--even for the very same item. It sounds ridiculous, and it is ridiculous--but the studies are pretty irrefutable. In one landmark experiment, two MIT professors auctioned off some highly desirable Boston Celtics tickets (this was during the Larry Bird era), allowing half the bidders to pay by credit card while the others had to pay cash. The average credit-card bid was twice the average cash bid.
The solution? Ask yourself whether you'd spend (or invest) the money in question if it came from another mental account. If the answer is no, don't do it.
--WE HATE LOSING MONEY EVEN MORE THAN WE LIKE GETTING IT. This "loss aversion," as the pros call it, makes us go to great lengths to avoid losses, sometimes to our financial detriment. One example: People are often overly conservative, investing in, say, fixed-income vehicles to the exclusion of stocks (which are riskier in the short term but historically have offered higher returns over the long run).
Or we'll do foolish things to avoid finalizing and accepting losses that have already happened--a phenomenon many of us know as throwing good money after bad. So we'll spend hundreds of dollars to fix an old car not because it makes economic sense, but because we've already spent a lot on it. Or we'll hold on to a lousy stock not because we think it's undervalued and will go back up, but because we can't deal with the fact that the stock was a bad choice. On the flip side, we often sell winning stocks not because we believe they've hit their market top but because we want to eliminate the possibility of future loss.
If you think you're immune, you're probably wrong. A 1998 study of actual investment accounts shows that investors are not only more likely to sell stocks that had gone up than those that had gone down, but also that the stocks investors do sell tend to outperform those they keep.
--SORRY, BUT YOU'RE NOT QUITE AS SMART AS YOU THINK. There's now hard research indicating that a majority of us assume that we are more skillful than we really are, especially with regard to our investing ability. Why? The reasons are numerous, ranging from so-called hindsight bias--the widespread tendency to believe, when looking back on a past event, that we "knew it would happen"--to basic misunderstandings about probability. A majority of investors, for example, think they have a better than average chance of beating the market--a proposition that's extremely unlikely. (Thomas Gilovich and Gary Belsky, whose book Why Smart People Make Big Money Mistakes--and How to Correct Them is a good introduction to behavioral finance, call this the "Lake Wobegon effect," after Garrison Keillor's fictional town where "all the children are above average.") This misconception is particularly prevalent in today's frothy market, with so many popular stocks having made spectacular gains.
What's wrong with being overly confident? Well, the dangers of hubris have been documented since antiquity, but recent research by University of California at Davis professor Terrance Odean puts a new spin on the theme: The more confident investors are, the more often they trade, and the more often they trade, the lower their investment returns.
Makes you wonder, doesn't it?