Behavioral Finance: An Introduction
Many articles on personal finance and investing provide valuable insight into the mechanics – what is a mutual fund? Why is diversification important? Why and how to rebalance your portfolio? However, writing about investments today would be incomplete without discussing the most important factor – you, as the investor, and actions you may or may not take that affect the long-term success of your investment strategy.
This article will serve as an introduction to the growing field of behavioral finance, which studies why people make certain decisions regarding their finances, particularly with their investments.
Over the past 40 years, research has found that investor behavior is not simply a conglomeration of random, personal deviations from one person to the next. We would not pay much attention to them if these behaviors were limited to a small subset of investors.
However, the prevailing view is that individual investors exhibit similar tendencies. Behavioral finance can trace its roots to the 1979 landmark paper, Prospect Theory: An Analysis for Decision Under Risk, by cognitive psychologists Daniel Kahneman and Amos Tversky, in which they examined decision-making and introduced ideas that would have far-reaching implications.
Kahneman and Tversky are considered two of the founding fathers of behavioral finance and, along with economist Richard Thaler, laid the groundwork for other minds to develop this field into what it is today. Further additions include investor overconfidence, herding (copying other investors), lack of portfolio diversification and the disposition effect.
We want to share what has been observed so that you can be aware of these concepts and mindful of your investment decisions. Commonly observed tendencies include:
- Overconfidence affecting trading frequency: There have been several studies linking investor overconfidence (overestimating our own knowledge and control over events) to higher levels of trading, with research indicating males on average tend to exhibit more overconfidence than females with regard to investing.
- Trading patterns affecting returns: Occasional buying and selling mutual funds is a necessary part of investing, such as when rebalancing your portfolio back to its target allocation.
However, excessive trading can reduce returns by increased trading costs and potentially realizing short-term capital gains (taxed at your highest income tax rate) if the investment is not held for more than a year. One paper found that the group of investors who had traded the most in the study trailed the market by 6.50 percent, whereas investors with an average level of trading only trailed by 1.50 percent.
- The disposition effect: The disposition effect is a phenomenon in which investors prefer to sell stocks whose value has appreciated since they were purchased (winners) and continue holding stocks that have decreased in value (losers).
Upon first glance, this may appear to be a rational decision. Investors are locking in their gains from an appreciated stock while giving their losers time to potentially rebound. The reason why this is deemed to be a blunder is due to its tax inefficiency of maximizing realized capital gains while not harvesting capital losses to offset them.
Investors are incurring a higher tax liability than necessary. The ideal tax strategy would instead postpone realizing capital gains as long as possible and realize capital losses when the losing stock is no longer considered a suitable holding.
The next time you are considering a change to your portfolio, take a moment to pause and think about what you are aiming to accomplish.
This article was written by Marshall Weintraub, CFP® and Michael Merrill, CFP®, CLU®, ChFC®. Weintraub and Merrill are financial advisors with the independent financial services firm, Finity Group, LLC, and wrote the book Financial Planning Basics for Doctors from which some excerpts were taken for this article. To ask them questions or arrange a consultation, email them at firstname.lastname@example.org or visit thefinitygroup.com. Office Address: 4380 SW Macadam Ave, Suite 245, Portland, OR 97239. Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Finity Group, LLC and Cambridge are not affiliated.
- Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55,773 – 806.
- Barber, B. M., & Odean, T. (2001). Boys will be boys: Gender, overconfidence, and common stock investment. Quarterly Journal of Economics, 116, 261–292.