Behavioral finance has become a popular topic amongst the investment community. From the technology bubble of 2000 to the recent financial crisis, the emotions of financial decision making have taken their toll on investors.
For more than 30 years, behavioral economists have studied the patterns of investors. Their conclusion: while the efficient market theory develops a strategy for the rational investor, investors are not rational. Behavioral finance studies how people actually behave in a financial setting.
Behavioral finance recognizes that people don’t buy numbers, they buy feelings. Studies have shown that investors feel more than double the pain when their portfolio loses value, versus the joy they feel when the portfolio increases by that same amount.
Irrational behavior occurs throughout these three phases: Investors anchor their expectations on great returns that come once every six years; they are disappointed in four of the six years because they achieved “typical” returns; and despondent when markets suffer that one in every six year fallout.
Investors increase their appetite for risk in up markets, taking on more risk than they should because investors feel that the existing current market conditions are permanent. In down markets, irrational behavior takes over and investors sell because again they think that market conditions are permanent, when in most cases they should actually be buying.
What can investors so to guard against irrational behavior?
Formulate financial goals. Defining financial goals is critical to creating a successful investment strategy. Understanding and identifying your goals will help create the foundation for your asset allocation.
Understand risk tolerance. Allocate your assets to your appropriate risk level and stay the course. Be fully aware that emotions may want to take you outside your tolerance for risk.
Maintain a consistent approach. Once you have formulated your asset allocation, stay with it. Investors allocate their assets for a reason: to optimize returns for the amount of risk they are willing to tolerate. Review asset allocations periodically and do not allow irrational behavior to dictate your decision making process.