Part 1: Introduction, Prospect Theory, Loss Aversion, Recency Bias

Principles for an Investment Strategy

Investor behaviors can be influenced by the psychologies, emotions, and biases that affect investment decisions.

About 30 years ago, a new field known as behavioral finance emerged. It created quite a stir as articles were published in academic journals, business magazines, and some mainstream newspapers. However, it can actually trace its roots back more than a century to books such as Extraordinary Popular Delusions and the Madness of Crowds authored by Charles Mackay in 1841, and Psychology of the Stock Market by G.C. Selden, published in 1912. The former wrote about the panics and schemes throughout history and how group behavior can ignite frenzies. The latter discussed the visceral and psychological forces at work in financial market participants—amateur and professional investors alike.

Behavioral finance can help to explain and increase the understanding of the reactions and reasoning patterns of investors, including the emotional processes involved and the degree to which they influence decision-making.

The pursuit of long-term financial goals through proper planning and investing can be undermined by protective instincts some clients may feel during periods of severe market dislocations and geopolitical adversity. Without the ability to control their situations, investors often feel heightened uncertainty when news flow is particularly unpredictable and the 24/7 nature of media access enables the same hyped news story to circulate repeatedly for an extended duration.

As investors, we are obviously influenced by various behavioral and psychological factors. Individuals who invest in stocks, bonds, mutual funds, and all other securities should consider implementing several safeguards that can help control mental errors and psychological roadblocks.

A key approach to controlling cognitive dissonance is for investors to consider the potential impact of a disciplined investment strategy underpinned by a sound financial plan. Following that vetting process, investors can further understand their responses to work to avoid “unforced errors” by focusing on a well-defined and consistently applied investment allocation.

Investors, in working with their Financial Advisors, should establish why they should use a unique or custom benchmark to measure portfolio or strategy-specific returns and how the strategies employed in the portfolio construct adheres to, and delivers on, their goals. These include, but are not limited to, near- and long-term asset and liability assumptions, risk tolerance and the investment returns targeted to achieve the desired outcome.

For example, an investor and Financial Advisor should set the ground rules for reactions to news events, market volatility, and other variables that will assist in evaluating the investment choices made and the response, if any, that should be taken. With that game plan in mind, investors should have the tools needed to understand causes of volatility.

In sum, investors can consider different ways to avoid the mental mistakes that behavioral theorists have identified through establishing a shared investment philosophy whereby investments are made to align with the long-term investment targets established as a byproduct of, and within, a robust financial planning process.

This mentality can help dissuade short-term activity that is often reactionary in nature due to the occurrence of an event that seems to create a pressing need to take action to advantage or avoid a certain expected outcome. This can result in activity that is inconsistent with one’s long-term investment objectives.

There are myriad behavioral responses identified by psychologists and social theorists that serve to describe commonly experienced phenomena by investors.

Throughout this journey of behavioral finance, we will introduce and describe behaviors that can impact investment performance. We will also illustrate some decisions influenced by these responses that may lead to an unwelcome outcome, and show that if mitigated before succumbing to its vagrancy, it can help.

Prospect Theory

We begin by visiting the notable work in behavioral psychology developed by Nobel Laureate Daniel Kahneman and Amos Tversky, called prospect theory*. The key finding in this study is that investors consistently overvalue the prospect of a tail event, i.e., a low-probability, high-impact outcome that can be either positive or negative, often interpreted from random, non-material, or spottily sourced information.

Decisions Based on Risk

An example of prospect theory can be found in playing the lottery. If there is a one in a million chance of winning a million dollars, then statistically, the expected value of this prospect is just one dollar. Yet, those who buy tickets will consistently pay more than one dollar for this positive tail event. Of course, knowing this probability, gaming officials expect lottery ticket buyers to overpay for a chance on this positive tail event, which is the very foundation upon which the multi-billion-dollar lottery and gambling industry is founded.

Now consider an “inverse lottery,” in which there is a one in a million chance of losing a million dollars. In theory, we should be willing to assume this risky prospect by accepting just one dollar to play. However, in practice, studies show we consistently demand more than a dollar to take on this negative tail event. In other words, we will demand a substantial “risk premium.”

Prospect theory explains that we tend to overvalue tail events because we are usually terrible at comprehending and therefore, quantifying, small probabilities*. Hence, the prospect of winning a million dollars, while in practice a negligible possibility, generates optimism that results in overpayment for the bet. Likewise, the possibility of losing a million dollars, while in practice a similarly negligible possibility, generates excessive pessimism, for which we demand payment of a “risk premium.”

Similarly, investors might be uncomfortable with the risk of owning stocks. This explains why stock market investors demand a risk premium—an excess prospective return— to own equities versus other assets such as bonds or cash equivalents.

Portfolio Implications

Meanwhile, the other side of prospect theory demonstrates that if investors are faced with the possibility of losing money, they often take on “riskier” decisions aimed at loss aversion (refraining from investing altogether). These investors tend to alter their revealed disposition toward, or tolerance for, risk substantially*.

This may result in underinvesting in stocks, holding only defensive stocks within a diversified portfolio of long-term investments, or holding excessive amounts of cash. It is the latter that is all too often familiar, borne from the fear that a sudden and sizeable market drawdown is approaching that could deeply scar the investor’s portfolio.

Assessing the tolerance for the inevitable periods of market volatility by way of proper planning, ongoing discussions, and reviews with one’s Financial Advisor (and regularly folding this into a dynamic and prudent asset allocation) can help to alleviate tensions associated with a market correction, or worse.

Adopting an objective and clinical approach to investment selection and portfolio maintenance might be helpful.

In sum, prospect theory, as in many other topics to be covered in this series, deals with the behavioral concept that people do not always behave rationally. This theory specifically, however, holds that there are persistent biases motivated by psychological factors that influence people’s choices under conditions that stress the cognitive ability to measure and assume wide degrees of uncertainty*.

Loss Aversion

Loss aversion is the tendency for investors to prefer to avoid a loss more so than the associated preference of realizing a gain. In fact, the pain of losing has been measured psychologically to be twice that of the pleasure associated with a gain. This often results in a lower, and/or higher acceptance of risk than the investor should otherwise be able, and willing, to bear*.

Perceived Safety Can be Costly

The cognitive effect from loss aversion can impose significant repercussions on investor behavior and can lead to staking out irrationally risk averse, and/or exceedingly risky positions at times.

For example, an investor who was distressed after the significant market decline decides to liquidate their entire equity holdings. Conversely, an investor may be inclined to hold on to a risky or losing position for a lengthy period simply to avoid realizing the loss in their portfolio.

Too many investors get a case of “get-even-itis” where they express a commitment to sell a losing position once they “get their money back.” Instead, decisions about buying, selling, or holding should be based on the merits of the company’s or market’s long-term prospects and its suitability within one’s risk budget.

Overcoming the Fear of Loss

Loss aversion is overcome by reminders to focus on long-term goals instead of daily, or short-term market machinations. It may help to refrain from checking on investments too frequently, or watching every news bite, which can often engender an emotionally driven investment decision. Discussions about an investor’s long-term financial plans, providing perspective especially during times of market tumult, and reinforcing the methodology for the asset allocation choices made to deliver on long-term goals, can be helpful in averting viscerally driven choices that can undermine long-term results.

In addition, framing can help to influence one’s perception of loss aversion. In other words, asking questions about what the risk of loss means and what could induce it, or performing an exercise to quantify it, may relieve some of the tension from the emotional tie.

Recency Bias

Recency bias is a behavioral tendency to favor most recent events over historic ones. For investors, it means being convinced a move in a security price, or the stock/bond market, that has occurred in the near past, might continue on its current path, up or down. These investors should consider the possibility that a change in direction could occur that is catalyzed by almost anything.

How it Impacts Investing

The behavioral mishap is to remember only the most recently presented information the best. Other information that may have preceded could be equally as important in evaluating the sustainability or longevity of a move in the market price, but that is either forgotten, or weighed as less important to the security or market’s future prospects.

An example in life might be the list of items intended to be bought at the store. The tendency, unless written down and carried with you, is to only remember that which was studied last from the list.

As it relates to investors, the application is found among those to think that a current stock market rally, or decline, will extend well into the future. That causes short-term decisions to be made about buying more as the market moves to elevated levels, otherwise known as buying at the top, or liquidating holdings into a severe market decline expecting the fallout to continue, otherwise, referred to as selling at or near the bottom.

Focusing on What is Important

What can investors do to avoid the mistake of “buying high and selling low?” Reverting back to one’s financial plan that spells out the long-term objectives and what is necessary to achieve financial success can help to pull the lens back from the moment.

This may also help to curb investor impulses to make knee-jerk decisions about something that just occurred, without a meaningful “step-back” to put it in the proper context.

Establishing a “cooling-off” period may also be a means of addressing so-called breaking news, stomach churning market volatility, or a rally-induced melt-up in a stock or market price that elicits a sense of fear that one is missing out (FOMO). Thinking in terms of what is inducing the direction of the stock or market, and evaluating its probability of persistence, may offer a broader prism through which to make a decision. Investors should be careful not to let what could be a fleeting point of interest occurring in the recent past change the course of a well-crafted financial plan.

* Source: Kahneman, Daniel; Tversky, Amos (1979). “Prospect Theory: An Analysis of Decision under Risk”. Econometrica.

Source: Murdock, Bennet B. (1962). “The serial position effect of free recall”. Journal of Experimental Psychology.

 

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This presentation has been prepared by Janney Investment Strategy Group (ISG) and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment. For additional information or questions, please consult with your Financial Advisor.

About the author

Mark Luschini

Chief Investment Strategist, President and Chief Investment Officer, Janney Capital Management

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