Thursday, April 23, 2009

What Did The Bear Do To Your Brain?

From IndexUniverse:

Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble ... give way to hope, fear and greed."

—Benjamin Graham

The terms investor psychology, behavioral finance and neuroeconomics have become synonymous with research conducted on how individuals make decisions regarding money.

Since the 1970s, this field of study has continued to gain legitimacy, culminating in 2002 when a Nobel Prize was awarded to psychologist Daniel Kahneman and experimental economist Vernon Smith for their landmark research.

The work of Kahneman and others provide empirical support to the notion that individual behavior does not align with traditional simplistic economic theories on financial decision making.

Traditional economic theories falsely assume that people rationally weigh costs and benefits to make the most economically rewarding decision. Behaviorist studies confirm that we often make financial decisions that do not yield the largest economic gains, appropriately account for risks or accurately assess probabilities.

Researchers have categorized these "behavioral traps" into various groups and subgroups. In particular, four of these seem most immediately relevant to current times and conditions:

  • Risk perceptions
  • Mental accounting issues
  • Anchoring tendencies
  • The gambler's fallacy

Turning our attention to understanding and identifying each could prove quite beneficial in these volatile and often confusing times.

1) Risk Perceptions

One of the greatest challenges that investors face is constructing an investment strategy that gets the investor where they want to go without taking on too much risk.

Studies have shown that tolerance for risk can change depending on a person's mood. If you are feeling happy, you may feel more positive about taking on risk; if you are feeling negative, you may be inclined to avoid risk. Intense positive or negative emotions can have a huge effect on our attitudes about financial risk.

But we have a difficult time quantifying risks and understanding the difference between rewarded risk and unrewarded risks for other reasons. One of the most common behavioral traps along these lines is called familiarity bias. This refers to investors who often falsely believe that a fund focusing on an asset class or sector they work with or know about on a personal level is less risky than the market as a whole.

Research shows that often this bias persists even after numerous companies, believed to be solid, have disappeared completely. Rationally, we should all agree that the likelihood of the entire stock market going to zero is lower than that of one company or industry doing so. Regardless, investors fail to understand the risk they face by not diversifying.

Often, investors get confused about which risks they should expect to be rewarded for—this is the reason that casinos and lotteries exist and thrive. A rational analysis of risk would include calculating expected payoffs before choosing among endeavors. Clearly, in the world of gambling and lotteries, expected payoffs are negative. In the market, however, trying to make these calculations is complicated and is often overlooked by investors. A diversified portfolio should present a positive expected return given enough time, rewarding investors for the risk taken.

When investors concentrate their portfolios in too few securities, industries, asset classes or countries, they take on additional risk without increasing expected returns....MORE