Behavioral Finance: Questioning the
Rationality Assumption
Much economic theory is based on the
belief that individuals behave in a rational manner and that all existing
information is embedded in the investment process. This assumption is the crux
of the efficient market hypothesis. (To read more on behavioral finance, see
Working Through The Efficient Market Hypothesis.)
But, researchers questioning this
assumption have uncovered evidence that rational behavior is not always as
prevalent as we might believe. Behavioral finance attempts to understand and
explain how human emotions influence investors in their decision-making
process. You'll be surprised at what they have found.
The Facts
In 2001 Dalbar, a financial-services
research firm, released a study entitled "Quantitative Analysis of
Investor Behavior", which concluded that average investors fail to achieve
market-index returns. It found that in the 17-year period to December 2000, the S&P 500 returned an average of 16.29% per year, while the typical equity
investor achieved only 5.32% for the same period - a startling 9% difference! It also found that during the same
period, the average fixed-income investor earned only a 6.08% return per year, while the
long-term Government Bond Index reaped 11.83%.
Why does this happen? There are a
myriad of possible explanations.
Regret Theory
Fear of regret, or simply regret,
theory deals with the emotional reaction people experience after realizing
they've made an error in judgment. Faced with the prospect of selling a stock,
investors become emotionally affected by the price at which they purchased the
stock. So, they avoid selling it as a way to avoid the regret of having made a
bad investment, as well as the embarrassment of reporting a loss. We all hate to
be wrong, don't we?
What investors should really ask
themselves when contemplating selling a stock is, "What are the
consequences of repeating the same purchase if this security were already
liquidated and would I invest in it again?" If the answer is "no",
it's time to sell; otherwise, the result is regret of buying a losing stock and
the regret of not selling when it became clear that a poor investment decision
was made - and a vicious cycle ensues where avoiding regret leads to more
regret.
Regret theory can also hold true for
investors when they discover that a stock they had only considered buying has
increased in value. Some investors avoid the possibility of feeling this regret
by following the conventional wisdom and buying only stocks that everyone else
is buying, rationalizing their decision with "everyone else is doing
it". Oddly enough, many people feel much less embarrassed about losing
money on a popular stock that half the world owns than about losing on an
unknown or unpopular stock.
Mental Accounting
Humans have a tendency to place
particular events into mental compartments, and the difference between these
compartments sometimes impacts our behavior more than the events themselves.
Say, for example, you aim to catch a
show at the local theater, and tickets are Rs100 each. When you get there you
realize you've lost a Rs100 bill. Do you buy a Rs100 ticket for the show anyway?
Behavior finance has found that roughly 88% of people in this situation would do so. Now, let's
say you paid for the Rs100 ticket in advance. When you arrive at the door, you realize your ticket is
at home. Would you pay Rs100 to purchase another? Only 40% of respondents would buy another.
Notice, however, that in both scenarios you're out Rs200 : different scenarios, same amount of
money, different mental compartments. Pretty silly, huh?
An investing example of mental
accounting is best illustrated by the hesitation to sell an investment that
once had monstrous gains and now has a modest gain. During an economic boom and
bull market, people get accustomed to healthy, albeit paper, gains. When the
market correction deflates investor's net worth, they're more hesitant to sell
at the smaller profit margin. They create mental compartments for the gains
they once had, causing them to wait for the return of that gainful period.
Prospect/Loss-Aversion Theory
It doesn't take a neurosurgeon to
know that people prefer a sure investment return to an uncertain one - we want
to get paid for taking on any extra risk. That's pretty reasonable.
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