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Why Are You So Irrational With Money?

August 15, 2016
We aren’t that good with money… or at least not as good as we think we are. As with traditional economics, conventional finance is based on theories that assume people behave rationally and predictably in their decision-making processes. Through observations and practice, academics have become aware of anomalies in behavior that do not align with these rationality-based theories and, similarly to behavioral economists, have sought to explain these true-to-reality actions rather than stress the theories of the “economic man”, Homo economicus.[1]

by Christian Butts, W’18, SEC (DERA) Intern 

The field of behavioral finance is rapidly growing as people continue to observe behavior that does not quite fit the accepted, conventional theories. Because people are not always rational and logical, psychologists, economists, and finance academics have collaborated to better understand certain phenomena. The two following anomalies prevent the market from being as efficient as possible and demonstrate our imperfect human behavior.

The Disposition Effect

This anomaly describes the tendency of investors to sell shares whose prices have recently increased while holding on to those shares with price recent decreases.[2] More easily stated, investors tend to sell their winners too soon and hold on to their losers too long. This observed behavior goes against rational economic theory, as a logical decision maker would sell her losers to prevent accumulating losses and hold onto winners until she has the most possible gains. This effect is a manifestation of Prospect theory, an idea developed by Kahneman and Tversky in 1979, which establishes that when faced with risky choices, decision makers evaluate gains and losses differently and most people weigh losses more heavily than equivalent gains.[3] Investors are inclined to hold on to losing stocks for too long because they do their best to avoid a prospective loss, but if the stocks are truly losers they will not recover and the investors will simply accumulate further losses. On the other hand, these investors jump the gun on winning stocks because they see the current gains as a guarantee and are afraid of the possibility that the stock’s price will decrease despite upward trends.

This is harmful because investors should be reacting appropriately to trends, capitalizing on gains and minimizing losses as needed. To avoid this, investors can utilize hedonic framing by thinking of gains as several smaller gains rather than one large gain to maximize positive utility, and thinking of losses as one large loss rather than several smaller losses to minimize negative utility. This is based off of the observed utility theories and human perceptions of gains and losses.

Researchers at the Federal Reserve did a study on whether or not this effect plagues even some of the most sophisticated investors or just those without strong finance backgrounds by observing short seller data.[4] Their study finds that even these very educated and return-sensitive traders are subject to the disposition effect which limits their profits perhaps in an even more noticeable way than for long-position traders. It is worthwhile to try to challenge human dispositions, but it does not always turn out very successful.

Mutual Fund Choice

As an intern at the Securities and Exchange Commission, I have been exposed to the agency’s mission of protecting investors and maintaining fair, orderly, and efficient markets as it pertains to economic analyses and research. An interesting study related to behavioral finance studies the manner in which retail investors choose mutual funds and how they demonstrate behavioral biases. First of all, investors often deal with choice paralysis, an inability to make a comprehensive decision when overloaded with information. When choosing an index fund to invest in, retail investors are often overwhelmed by the number of variables on which the funds are compared which often leads them to make their decisions on irrelevant or less important factors. Most financial professionals will agree that index funds that follow the S&P500 are essentially all very similar, so the best way to choose a fund is a pure cost comparison. Rather than choosing funds based on current assets, growth rates, ROE, or popularity, investors should seek to limit their costs when they buy into a fund that will simply follow the market. In terms of regulation, an agency could consider introducing a policy through registered brokers that gives investors a message when there are similar, lower cost funds available. These messages would not require the investors to switch brokers or switch funds, but would only make them aware of other options. When making the initial choice, many unsophisticated investors are not aware of the best factors of comparison, so it may be worthwhile to provide to them another opportunity to make a better choice.

Other Concepts

Behavioral biases affect our financial decisions in other ways and realms than those that I described, too.[5] For example, our opinions are often based on reference points that can be irrelevant to the decisions we are making due to anchoring which can lead to subpar (non-equilibrium) outcomes. Most of us tend to use mental accounting to separate money into separate accounts based on different sources, intents, and functions we think each account should serve, but it becomes illogical when a person has debt in one realm and excess in another. Another bias that is also commonly observed both in and outside of financial decision-making is herd behavior, which is the tendency for individuals to mimic the actions of a larger group when they would not make that choice if left to their own devices. Human behavior is such that sometimes these inclinations seem so unconscious they are unavoidable, but the more we know, the more we can seek to adjust accordingly and behave as rationally as possible.

References

  [1] http://www.investopedia.com/university/behavioral_finance/behavioral2.asp

  [2] Taylor, L. (2000, March 31). The disposition effect: Do New Zealand investors keep their mistakes? (Thesis). Retrieved from http://hdl.handle.net/10523/1388

  [3] Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-291. doi:1. Retrieved from http://www.jstor.org/stable/1914185

  [4] von Beschwitz, Bastian and Massimo Massa (2015). Biased Shorts: Short sellers’ Disposition Effect and Limits to Arbitrage. International Finance Discussion Papers 1147.

  [5] http://www.investopedia.com/university/behavioral_finance/behavioral12.asp

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