Behavioral Finance (part 4 of 5): Looking at the Way Your Thinking and Behavior Affects Your Investing
Part 4 in a series of 5.
In this installment of our series on problematic financial behaviors, we will take a look at the idea of Considering the Past.
Problem: Considering the Past
In looking at the study of behavioral finance, we are mainly concerned with which factors outside the financial markets affect our investing. One of the greatest external factors is that of our own memory. It is amazing to see just how different our memories of an event may be from the actual outcome of that event. That is because memory is not simply a transcription of an event, but also a recording of the emotions that event brought into our lives.
There are really two areas to deal with when our memories of the past are involved. The first is whether the event was pleasurable or painful. The second is how we feel about the outcome of prior decisions—are we proud of those decisions or are we ashamed or saddened by them?
When it comes to any event, it is the level of pain or pleasure that affects us most. For example, if you buy a new car and then try to sell it within the first few weeks, you will see a sizable loss due to the cost of depreciation. That would be a very painful event. However, if you buy the new car and then sell it several years later you will still lose the cost of depreciation, but it will be far less painful. Why is this? Because the loss was spread out over a longer timeframe.
The same is true with investments, and applies to pleasurable experiences as well. For instance, take a look at this example about two stocks from John Nosfinger’s book, “The Psychology of Investing”. The example talks about a biotechnology stock and a pharmaceutical stock that were purchased at the beginning of the year, both at the same price of $100:
“People feel better about experiences with a high pleasure peak and end. Consider a scenario in which the two stocks increased in price. The biotechnology stock increased to $125 over the year. The pharmaceutical stock rose dramatically to $120 at the end of the year. The memories of these events cause the investor to feel better about the pharmaceutical stock, even though it did not perform as well.”
The bottom line is many times we may make a poor choice simply because our memories fail to recall past experiences correctly. Most times, this causes us to take on excessive amounts of risk, which may well lead to disastrous consequences.
The other issue of memory concerns how we feel about an event that took place in the past. Psychologists call this a problem with cognitive dissonance. The idea here is that we adjust our recollection of past events to match with our own perceptions of ourselves. Cognitive dissonance works something like this: We all like to believe that we are good decision makers. However, we have all made poor choices in the past that led to negative consequences. Because those poor decisions contradict our own positive self-image, our mind tends to ignore, downplay, or even forget the poor choice. In some cases, we may even change our beliefs in order to be consistent with current decisions.
When it comes to our investments, we tend to reduce the impact of poor returns and accentuate good returns. By doing this, we end up overestimating both our own past returns and the potential future performance of our accounts. It is a very common occurrence for me to speak with people who consistently overestimate both the historical return for their own portfolio as well as that of the markets in general. This sets them up for disappointment on two levels. First, their recollection of their own performance may be unrealistically high and will likely never be replicated. Second, their over-estimation of the market’s performance can set them up for disappointment when those lofty returns are not achieved. My job then becomes helping them revise those expectations to realistic levels that can be achieved and used to plan for the future.
This was an all-too-common occurrence during 2000, when the markets were just beginning their slide downward as the dot-com bubble finally burst. Investors still believed that the skyrocketing gains of those high-tech startups were still abundant. And we saw the same behavior pattern emerge following the peak of the housing market bubble in 2006, as sellers set unrealistic prices for their houses yet received no buying interest at those levels and they could not understand why. The pleasurable memory of rising home prices made them want to believe it will continue to happen, even in the face of rapidly declining prices.
Memory can indeed be a tricky thing. It can make us act in ways that are detrimental to our long-term financial health. However, once we understand how it can affect us, we can start to remove those inaccurate perceptions from the equation and become better investors.
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