The High Cost of Emotion in Personal Finance

Humans are hard-wired in ways that helped our ancestors survive over thousands of years. Investing in markets is a recent concept – the New York Stock Exchange (NYSE) was founded in 1817. Unfortunately, the cognitive processes that aided our ancestors may undermine our success in modern markets. Behavioral finance is an emerging field that examines how people use the tools of finance, rather than studying the tools themselves.

One common behavioral mistake is known as “myopic loss aversion.” Behavioralists have estimated that people hate losses roughly two-and-a-half times as much as they like gains. We exert more effort to avoid losses than to achieve gain. Suppose an investor’s portfolio rose 40% and then dropped 20%. He/she would feel the loss about 2.5 times as much as the gain. The drop causes heightened loss aversion, potentially leading the investor to panic and act against what he/she knows is rational.

See Also: Learn More About Investor Psychology From Kiplinger.com’s Your Mind, Your Money Columns

Often when someone talks about losing money, the conclusion is some form of “this wouldn’t have happened if I were paying more attention.” We maintain our health by going to doctors. We take care of our teeth by visiting the dentist, and most of us don’t work on our own cars. So why, when it comes to finances, are many investors adamant that they can do it on their own? We willingly seek specialists for almost every arena outside of investing. The behavioral bias coming into play is overconfidence.

Let’s say John suffers a 20% loss. He feels regret. Loss aversion makes his 20% loss feel like a 50% loss. Rather than realizing that he may benefit from professional help, he thinks he’s just unlucky. Overconfidence convinces him he will succeed the next time. He decides the market will fall further, and by selling his portfolio he eliminates the possibility of feeling more pain from losses. Overconfidence leads John to believe that not only does he know when to sell, but also when it is time to invest again.

Investing problems can be compounded by the recency bias – believing that what happened recently will continue in the future. During bull markets, we are more likely to believe stocks will continue going up so we invest more. Bear markets feel like they will never end and make us want to stuff all our money under the mattress. Our rational side knows market timing is a fool’s game and that we must weather the tough times in order to benefit from bull markets. Yet, short-term trends sometimes drive our decisions.

The same goes for evaluating mutual fund managers. All evidence shows that it takes at least a full market cycle to to evaluate a manager’s returns; having ten years or more would be even better. A manager with a few bad quarters, but a long-term track record, could still be great. Despite this knowledge, we often overreact to what happened recently.

A recent study by the Investment Company Institute illustrates how market returns have impacted mutual fund inflows. The chart shows the percentage change in monthly equity mutual fund inflows and the year-over-year percentage change in the MSCI All Country World Index between 2000 and 2014.

Researchers measured the cost of this approach by comparing the performance of return chasing with a buy-and-hold strategy. The research reveals return chasing leaves nearly 2% on the table annually. Rather than earning 10% annually over the long term, those impaired by the recency bias took a 20% haircut and ended up with 8% annualized returns.

Understanding the lessons of behavioral finance can greatly increase your odds of achieving financial freedom. Realizing that these tendencies exist is the first step in making better decisions. Remember, we hate losses roughly two-and-a-half times as much as we like gains. Fight the urge to panic over investment losses, and realize our tendency to overreact to recent history. Working with a financial adviser can help you stay on track. It’s easy to get emotional when managing your own money. An objective partner can help you overcome harmful behavior biases and remain focused on long-term goals.

Sources: Bloomberg, CFA Institute, Wall Street Journal, About Archeology, Federal Reserve Bank of St. Louis, Investment Company Institute, Morgan Stanley International

David has served as CEO of Mercer Advisors since 2008. He is responsible for the firm’s strategic vision, business plan execution, and organizational structure.

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