Analyzing Mind Games Investors Play Helps Explain Markets’ Ups and Downs
The study of why investors behave the way they do is finally being turned over to the proper authorities: psychotherapists.
Many are now hired by investment companies to find out why they make their buy and sell decisions, and how they time those decisions. At the same time, a great deal of academic research is being generated on those same questions.
It’s probably no surprise to most investors, but we do tend to psyche ourselves into making mistakes. Besides swinging between the two market-driving emotions of fear and greed, we allow our moods, misjudgments and psychological foibles drive down our nest eggs with bad investment decisions.
Recently, the stock market has been more driven by psychology than in the past. It’s been what the pros call a “momentum” market, which means that investors seem to be playing follow the leader to a greater extent than usual.
What happens in a momentum market? Lots and lots of volatility, as buyers buy what’s going up and sell what’s going down, without too much regard for the value or background of the company.
They do this because they are afraid of being left out of the crowd. They figure that being wrong is bad, but being the only one wrong is worse. At least if everyone is wrong, they won’t have to feel stupid.
That’s just one of many psychological tricks we play on ourselves with our money. There are six common “investor mistakes” that market players make most often, according to new research by R. Douglas Van Eaton, a finance professor at the University of North Texas in Denton.
Writing in the April issue of American Assn. of Individual Investors’ Journal, he says investors who learn to identify these mistakes can learn not to make them. Even better, in some cases investors can learn to exploit market anomalies caused by the errors in perception and judgment of other investors.
These are the six common psychological errors that Van Eaton identifies, along with the investing behavior associated with them:
* Overconfidence. Now here’s a non-surprise: Men suffer from this more than women, but both sexes have some overconfidence both in themselves and in their investments. These investors tend to be optimistic about their chosen stocks and about their abilities to time their investments. They also tend to minimize historical events and returns, believing that the here and now is much more important than what happened in the past. The overconfident tend to overtrade and pay too much for their investments, suggests Van Eaton, who calls the “this time it’s different cry” perilous.
* Fear of regret. Investors who worry too much about feeling bad later tend to sell their winners too soon and hang onto their losers too long. It’s better to admit mistakes and sell dogs before they keep going down. Some investors protect themselves from this fear by putting stop-loss orders on their stocks, instructing their brokers to sell automatically when a company’s share price drops by 10% or 15%.
* Cognitive dissonance, a.k.a. “knowing better.” When investors avoid information that might conflict with their beliefs, they are trying to minimize the cognitive dissonance between what they know and what they do. For example, they buy a mutual fund and then ignore all articles about their fund or competing funds, because they are afraid they’ll read bad news about their decision. Obviously, investors need to stay informed even if the news isn’t good.
* Anchoring. This is a brain shortcut that investors take when they “anchor” a company’s value to its recent share price. They might think that a recent high price is the right price for a stock, for example. So, when it falls dramatically, they’ll think they’re getting a bargain, when they might be getting a very troubled, never-to-see-those-highs-again company. Investors who buy companies low and then sell because they get afraid at high prices also might be anchoring by mentally fixing the company’s worth at its low value.
* Representativeness. A few characteristics define a company. So a tech company is considered a good buy when “tech stocks are good” and a bad buy when “tech stocks are bad.” There are a lot of criteria that make a company a good or bad investment, and there’s a lot of money to be made by investors who look at the data and don’t wait for other investors to classify a firm as good or bad.
* Myopic risk aversion. That’s old-fashioned thinking short term with long-term money. Don’t move money around chasing last year’s hot funds, and don’t keep it invested too cautiously in bonds or money market funds if you won’t be needing it for five or 10 years. Plan your acceptable risk by the holding period.
Investors who are interested in the psychology of the market and would like to delve into how behavior is affecting their returns today can find several leading researchers and their academic papers at this behavioral finance Web site: https://www.undiscoveredmanagers.com/Behavioral%20Finance.htm.
