We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
The above is attributed to Warren Buffett, the Oracle of Omaha, and one of America’s wealthiest persons. It points out his contrarian style and his value oriented approach to investing. It is often pointed out that value investing, as opposed to growth investing, will lead to statistically greater returns[i]. That is not the subject, however, of this tip. This tip is about human behavior and investors are human. They make mistakes and they may behave irrationally and human behavior affects investment decisions, just as it affects others spheres of life. By studying human behavior and identifying common investor mistakes, the field of behavioral finance can contribute to improving returns or reducing investors’ mistakes that emerge from the confluence of finance and psychology.
What are some common behaviors that we observe and from which we can learn to behave more rationally?
One of the first is overconfidence. Nothing can lead to regret more quickly than success. An investment decision that turns out to be great often leads investors to overestimate their knowledge and their abilities. Such an increase in confidence may cause them to increase the amount of risk they are willing to take with their investments. Investors need a plan – a well thought out plan. Then, they need to stick with the plan, while constantly learning and modifying as necessary.
A good lesson, that is hard to learn, is to not allow sunk costs to change your decision. We are disposed to hold onto investment losses, as we do not want to lock in “regret”. We do not want to regret, so we postpone this feeling and hold investments that have losses (or not taking some gains) in the mistaken belief that the investment will recover (or continue to increase). (Investors are, unfortunately, more likely to take small gains and let losses increase, as they do not want to regret their bad decisions. We think less about opportunity costs.)
Closely related is the Ostrich effect, where the investor simply puts her head in the sand. This is true on many levels. Investors are reluctant to cut their losses and ignore them until the pain drives them to sell – often just before the market turns around. (Reminder: Be greedy when others are fearful.) The same thing can happen when markets have been on a sustained upward run, when valuations are quite high.
An easy mistake to make is for investors to consider winnings to be house money and to rationalize their losses, as simply money that wasn’t really theirs. First, investing is not gambling. Investing is the implementation of a plan. “Gamblers” who buy a stock and win will often seek riskier investments with their house money. At the same time, if they invest and lose, they again tend to buy riskier investments in an effort to recoup their initial losses. Don’t play this game. The house always wins.
It has been observed that investors are more comfortable investing in companies with whom they are familiar. Familiarity increases comfort and may come from building investors’ confidence in their knowledge or a sense of control. Yet, when we only invest in companies in a single geographic region or if we combine employment and investments, we have a diversification problem. (If you don’t believe me, ask an ex-employee of Enron.)
The fancy word for having a selective memory is cognitive dissonance, where our mind remembers successful investment decisions but represses the bad ones. One must learn from their mistakes, before they go broke learning.
When individuals act together, they are known to be herding. Yes, like the cows coming to the barn to be milked. If investors lack the discipline to have independent thoughts and to be committed to their plan, their desire to be a part of the parade will often lead them to get in line when the parade is about over. As such, you buy when the market is high (greed) and sell when it is low (fear). Of course, herding will magnify individual investors’ biases as we have others – many others – who seem to agree with us.
Investors must learn to overcome detrimental behaviors, in order to be committed to financial success. While human behavior is a part of the market for investments and human behavior helps markets maintain their efficiency, we are all human. Try to remove emotions from financial decisions and limit your use of trial and error. Become informed, develop a plan, save more money, stay diversified, and make good decisions over a long period of time. If you do, you will reach your goals. Count on it!
[i] One of our past-colleagues has written much about this topic and a short “lay-press” article about the subject is here.