The Psychology of Investing

Understand The Emotions That Underlie Your Investment Decisions

By Wendy J. Hackett-Dominguez

In an ideal scenario, investors would buy and sell investments without emotion.  Unfortunately, research has shown that investors do not make decisions in a vacuum.

Feelings of loss, pride, and regret can cloud the investment decision process.  Investors may make better decisions by trying to understand the behavioral factors that can influence their judgment.

There are three overriding behavior tendencies investors face every day: herd mentality, risk aversion and frame of reference.

Herd Mentality

Research has suggested that "following the herd" on investment decisions has the potential to provide investors with many psychological benefits.

Herding reduces the time needed to properly analyze an investment decision.  It can also help reduce feelings of regret if the investment choice was a bad one.  Investors can find comfort knowing that they were not alone in their decision.  Herding can also be a powerful tool in influencing market movements.

An example of how the stock market can be fueled by herd behavior was the stock market crash on October 19, 1987.  On that day, the Dow Jones Industrial Average dropped nearly 23% in the largest single day decline in history.  On that day, no significant news events were reported which could account for the plunge.

To understand the behavior of investors during this market drop, Robert J. Shiller of Yale University conducted a survey of nearly 900 investors within a few days of the 1987 crash.  One of the most interesting findings of his study was that 25% of the investors said the crash was caused by irrational behavior of investors.  Only excessive prices (33%) and computerized trading (25%) were mentioned nearly as often.

In the survey, Shiller asked participants to cite what they thought was more responsible for the crash:  economic fundamentals, such as corporate profits or interest rates, or investor psychology.  A surprising two thirds of the surveyed investors cited psychology, rather than economic justification.

Shiller concluded that the piece of information most relevant to investors during the market crash was declining stock prices.  Investors were not concerned with fundamental changes in the expected future value of corporate earnings.  As stock prices fell, investors adopted a herd mentality, causing stock prices to decline even further.

Risk Aversion

The reason investors tend to favor a sure thing over an alternate choice that has an equal or higher expected return can be described as being risk averse.  The aversion investors have towards risk stems from two very different feelings:  pride and remorse.

Pride is the pleasurable feeling investors have when investments do well.  Remorse is the painful feeling investors have when their investments do poorly and they second guess themselves.  Remorse tends to be felt more deeply than pride.  Remorse compels people to avoid situations in which the chances of their feeling remorseful are perceived to be high.

Investors may also perceive risk in situations they have not experienced before.  This aversion is a major cause of poor investment returns on behalf of many investors.

In a study by Morningstar Mutual Funds, results from individual investors were compared against the results of the 219 growth funds they followed for the five year period ending May 31, 1994.  The study showed that the average growth stock fund gained 12.5% per year over the 5 year period, while the average investor in those funds lost 2.2% per year.

Why such a huge difference?  First, investors are attracted to stock funds after the market has risen for a while and they feel comfortable.  Much of the ultimate gain has already been achieved by the time they buy.  Then when a correction occurs, they become risk averse and sell their investments.

Frame of Reference

Another factor that affects investor decision making is the investor's particular frame of reference at the time of a decision.  Research has shown that when asked to choose among two alternatives, people will reach opposite decisions based solely on their current situation.  The two most common investor frames of reference are situations in which the investor is currently losing money or currently making money.

Research has shown that investors tend to become more risk averse when they are facing the prospect of a gain and more risk seeking when they are facing the prospect of a loss.  Terrance Odean, a professor at University of California at Davis, performed a study on trading behavior of investors.  He found that investors tend to sell more of their "winning" stocks than their "losers" - even though the winning investments they sell subsequently outperform the losers they continue to hold.  His study also concluded that investors don't want to take additional risks with stocks in which they have already made money.  However, they will tend to hold on and risk additional losses with stocks they are currently losing money on.

Conclusion

All investors want to make the right decisions about their investments.  But research has shown that investors have a tendency for types of behavior that are not beneficial to the management of their investments.

The best course of action for a portfolio may be contrary to an investor's desire to run with the herd, shield themselves from risk and/or regret.  By understanding these behavioral tendencies, investors can make a conscious effort to correct these behaviors.  In the end, the best defense against these tendencies is to do a lot of homework before choosing an investment.  Investors should determine their investment goals and the time frame that their money can work for them.  Then, based on those determinants, pick an investment strategy and stick to it.