Finding a Comfort Zone with Behavioral Investing

Finding a Comfort Zone with Behavioral Investing

The past week has been a wild ride for stock markets.  Markets across the globe suffered huge losses in a short period of time.  Newspapers ran with headlines about a global meltdown, financial news stations ran nightly specials and Matt Drudge declared “The Great Fall of China”.

For the majority of people who don’t spend their lives plugged into financial markets, this type of news flow catches their attention.  As they notice their brokerage accounts, 401(k)’s and IRAs losing value, worry creeps.

“Is pundit XYZ I saw on the 11 o’clock news right about this being the beginning of another financial meltdown?  I don’t want to do go through 2008 again.  What do I do?  Should I sell?  I think I’ll sell.”

When we worry, emotions begin to weigh more on decisions than logic and that’s where mistakes can happen.  This has always been a problem for investors.  Emotional mistakes can kill.  We know they can.  So why do they happen so frequently?

Well for starters, people think much differently when they are losing money than when they are making it.  There’s no getting around that.  Losing money doesn’t feel good.  But is it ok?  Brent Steenbarger has an incredible piece in Forbes this week about the psychological problems that affect investors.   He compared investing to decisions we have to make in life:

The commitments that, over time, can yield considerable life satisfaction often require short-term sacrifices of what would make us happy at the moment. When our longer-term aspirations conflict with what would gratify us in the near-term, we have the makings of a cognitive/emotional mismatch.

When there is a cognitive/emotional mismatch, we are prone to making poor decisions.  Once we agree on the premise that a large number of investment mistakes is driven by emotion, we can then try to figure out why.

To find a solution to this problem we have to work backward.  If emotions are leading to poor decisions, what then, is the cause of the emotions?  The answer to this question shows us the real problem.  It is likely that investors make poor, emotionally driven decisions because they don’t have or do not understand what their investment plan was.  They were uncomfortable, uneasy and unsure of what to do.

I think this is a very solvable problem.  Any advisor will tell you that their major responsibility is to match people’s investments with their goals.  I’d take that one step further and say it is of equal importance that I match my clients with investments that they understand.  With understanding comes greater comfort.  With greater comfort comes fewer emotions and fewer emotions means a decreased likelihood of harmful decisions.

While I don’t think average investors need a deep understanding of asset classes, stock markets and interest rates, I believe it is of paramount importance that they have a good grasp on the philosophy behind their investments. If somebody asks one of my clients how their money is invested, I don’t want the answer to be, “I give it to my advisor.”  I work extremely hard to educate my clients so that with relative ease and brevity, they should be able to outline the ideas that guide their investment plan.

In my experience, I have found the greatest level of comfort by focusing on the simplest, yet most influential factor that drives investment prices.  People.

I believe…

  • Assets are not priced based on economic data or business fundamentals.  If they were, there would be no need for markets.
  • Market prices reflect the perceived value of an asset based on all available information.  This perception is heavily influenced by exogenous factors such as investor sentiment and human emotion.
  • Because humans are prone to irrational behavior, their actions and emotions are fairly random.
  • Beyond the impact of emotion, markets are also highly susceptible to the butterfly effect.  This makes reliable prediction of a globally interconnected economy nearly impossible.
  • System-based investing allows one to overcome the challenges presented by chaotic environments by acknowledging randomness and removing emotion from the decision-making process entirely.

Quite simply, market prices are determined by the aggregate behavior of humans, nothing more.  For that reason, the study of this behavior is at the center of my investment philosophy.

I believe cycles of fear and greed move markets up and down.  I believe in value, momentum and trend.  Not only is it is much easier for me to explain these phenomena to clients than explaining why I think East Asian emerging markets deserve 6.5% of their equity allocation, but it is also much easier for average investors to understand.

There are hundreds of ways to make money when investing.  Solving the cognitive/emotional response problem is a key to success.  The best advice I can possibly give is to find an investment philosophy you understand, believe in and are comfortable with.  If you do, the next time global stock markets are the top story on the evening news, you won’t have to worry too much about whether or not you are making a bad decision.

For me, the concepts behind behavioral investing are easy to stand behind.  I can look past the minutia of price ratios, earnings reports, interest rates, quantitative easing and credit worries and instead focus on very broad factors that have big impacts.  It is simple.  I understand it and I believe in it.  Those are three of the major ingredients to any winning investment plan.

Further reading…

Investing in Human Behavior

Avoid Volatility and Preserve Emotional Capital

Tim Brennan

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