Investment Thought Leader, James Graves
Traditional investment theory is based on investors acting rationally with regard to advancing their own financial interests, within their limits of risk tolerance. The theory also presumes that in a liquid market items traded are fairly and efficiently valued. In reality, human emotion and bias can influence investment actions and results in irrational ways that can be either positive or negative. The discipline of identifying and gauging behavioral influence on actions and on markets is called “behavioral finance.” The magazine, “Psychology Today,” defines behavioral finance as the ways psychology affects investor behavior and financial markets.
James Graves, Investment Advisor and Principal at Joppa Mill Advisors said, “An important oversight in classic investment theory is ignoring the fact that investors are humans who don’t always act rationally. Assuming only rationality in investing can lead to unexpected and unproductive results.” As an example, Graves points to the recent post-Presidential election period where many were wary of the effects of impending tariffs on the world economy. Graves notes that the feeling of fear and apprehension drove some to liquidate their investment portfolios, even though the rational value of their investments had not materially changed. The result, for those liquidators, was that they missed out on the subsequent upturn in the markets.
Read more: Behavioral Finance: 7 Ways Unwitting Emotions And Biases Can Adversely Affect InvestmentsGraves believes that to achieve the best long-term investment results, one should be mindful of behavioral financial effects and, in the long-term, work to minimize their influence. For the amateur investor, understanding behavioral influence and detaching rational investment decisions from it’s effects can often be difficult to do. Graves has identified 7 behavioral factors that can be especially significant influencers. They include:
1) Herding
As with our post-Presidential election example above, the non-professional opinions of friends, family and pundits must be weighed against the realities of value. Just because the so-called herd is moving in one direction doesn’t make their action wise.
2) Emotional Bias
There is little room for excessive emotions in financial analysis and planning. Such emotions as fear, anxiety, excitement, exuberance and others can motivate investors to be pushed in the wrong direction even in the face of sound investment analysis.
3) Confirmation Bias
If an investor strongly believes a certain way, they can sometimes undervalue or ignore information and facts that support an opposing viewpoint. One-sidedness can cause investors to maintain a false sense of over-confidence because they are missing seeing the total picture.
4) Recency Bias
When it comes to market movement, amateur investors can put too much stock in prior events or cycles and the degree of influence they may have on the future. Fallacious or exaggerated reactions to past stimuli, cycles or trends can lead to misguided decisions in the future.
5) Risk Avoidance
As damaging as exuberance or over-confidence can be, the opposite, or risk intolerance can also hold investors back from reaping potential gains. Today, risk tolerance can easily be gauged by relatively easy-to-take surveys. By knowing risk level, investors and advisors can assess and recommend the most comfortable investments that maximize results for that level.
6) Endowment Bias
Many amateur investors retain ownership of losing investments for a much longer time period than they should, hoping they will come back in value. The prudent investor should remove the emotional connection to a stock and craft a strategy for adroit liquidation and transfer of the remaining asset’s value into productive investments that most quickly get back on the growth path.
7) FOMO (Fear Of Missing Out)
Amateur investors can be motivated by greed into engaging in irrational risk because they believe that “it can’t miss”.
Said Graves, “To achieve the most effective long-term investing results, it’s important to understand basic financial principals and use them to analyze whether you believe a company will be a prudent investment. It will also be important to know what level is the risk tolerance in order to be able to decide whether the investment, under consideration will be in one’s comfort zone. A professional investment advisor, who is trained to filter out emotions in order to keep you on course to achieve long-term goals, can be quite helpful in these situations.”