The Psychology of Investing

Janney’s Chief Investment Strategist continues to explore behavioral finance and investment principles.

In Part 1 of this series, readers were introduced to behavioral finance and how it can help to explain the reactions and reasoning patterns of investors. Three concepts—prospect theory, loss aversion, and recency bias—are covered in the first part and establish the basis for the research that forms behavioral economics and finance.

There are many more behavioral responses identified by psychologists and social theorists that serve to describe commonly experienced phenomena by investors. Recognizing, and actively managing, behavioral biases could potentially help investors avoid an unwelcome outcome.

Investors should consider several safeguards that could help with developing clear investment judgment and a focus on long-term objectives. They should also consider the potential impact of a disciplined investment strategy underpinned by a sound financial plan. In working with their Financial Advisors, investors should establish a philosophy whereby investments are made to align with their long-term goals.

This second part of Behavioral Finance and Investment Principles further examines the behaviors and emotions that affect investment decisions, specifically familiarity and framing biases and mental accounting.

Familiarity Bias

Familiarity bias is a mental shortcut investors often employ in which they tend to lean heavily on their own most familiar experiences in order to process decisions^*. This bias is considered one of the effects of a reliance on the availability heuristic— the likelihood of events is estimated based on the ease with which relevant instances come to mind^†.

How Familiarity Bias Impacts Investment Decision-Making

Familiarity bias is evident when investors show partiality toward stocks belonging to their home country, the company they work for, or products they use and like. For example, a bias toward investing only in U.S. equities, even though more than 40% of the total capitalization of global equities is in overseas markets^‡.

To illustrate another example: An employee of a publicly traded company holds an abundance of the employer’s stock, representing a large percentage of their total investable assets. The employee believes they have a reasonable understanding of the company’s business activities and growth potential. However, my experience suggests that individuals tend to see things differently when considering a prudently diversified portfolio because they are aware of the risk of placing all your eggs in one basket.

Familiarity bias could also manifest in allocating investments between stocks and bonds, where an investor may be uncomfortable venturing into the stock market because of unfamiliarity, stocks’ seemingly volatile behavior, or perhaps not knowing the market’s long history of generating strong returns throughout various economic cycles and unpredictable events. See chart, Current Value of $1,000 Invested in 1926.

Portfolio Diversification and Reducing Risk

In the aforementioned examples, familiarity bias could lead to lost opportunities to generate investment results that potentially might boost overall portfolio returns. In other words, overconcentration in a single stock, sector, or asset class, exposes one to possible portfolio risks. These risks include the loss of capital, wide swings in the portfolio’s values, or missed opportunities to earn a greater return on capital. Any of these consequences could potentially undermine the investor’s fortitude to invest in a manner congruent with their long-term objectives or to stay the course during times of market volatility.

A solid financial plan, administered by a Financial Advisor, might help resolve the instinct to adhere only to what is familiar. Establishing a plan might also ease the anxiety an investor may have about venturing into unknown areas of investing. Together, investor and advisor can identify areas where there might be undue risk and establish a method for controlling or mitigating it.

Framing Bias

Framing bias, or framing effect§, occurs when someone is influenced by the way information is being presented, suggesting the delivery of it may help “frame” or guide the way one interprets it. I have seen this behavioral shortcoming cause investors to make decisions with less than a full accounting of the matter.

The Power of Influence on Investor Behavior

Framing bias represents a cognitive limitation that may influence the way an investor perceives news about the economy or financial markets. For example, a hypedup “breaking news” story might be reckoned to carry more weight than other information that is actually more important but released the same day with less fanfare. In addition, I have observed how the presentation of market or stock movements affects investor behavior.

Different Perspectives Could Provide Insight

In my experience, considering various perspectives in order to see the information in its proper context is a way to avoid an unwanted framing effect.

Filtering emotionally charged news with facts and opinions from a variety of sources, especially from opposing viewpoints, may help diminish the risk of a misguided reaction to headlines and hype.

In regards to portfolio management, investors could look at current structure and performance through past and future lenses to see how their portfolio measures up against past objectives and expectations for the future.

For long-term investors, financial planning may offer objectivity when identifying goals. It could keep these investors on track no matter how an investment is being framed. With support from their Financial Advisors, they could consider alternative views of the same information and data and decide if it is wise to therefore realign expectations and goals. This can help investors overcome framing bias to make well-informed financial decisions.

Mental Accounting

A bias can be observed in behavioral finance that relates to different emotions attached to the budgeting and categorization of expenditures—an individual’s mental “income” and “savings” accounts. This separation into different buckets is known as mental accounting^¶.

The Investment Dilemmas this Tendency Might Pose

In personal finance practice, mental accounting means that investors and households create a cognitive distinction in their willingness to draw on income versus savings for spending purposes. Certainly, there might be a physical difference between savings and checking accounts at a bank or financial institution and an account used for achieving long-term goals. The latter is more likely to be an investment account comprised of stocks and bonds in some form congruent with the investor’s risk tolerance.

For market observers, the mental accounting bias might help to explain the recent “search-for-yield” phenomenon. On the surface, the search for yield could potentially make sense given the current monetary policy setting and the low yields offered by most high-quality fixed income investments. A possible dilemma for investors is accepting the lower yields offered by fixed securities perceived to be safe vs. stretching to find yield in riskier subsets of the bond market or in asset classes where dividend-paying stocks are luring.

From my point of view, making the distinction between yield and capital appreciation may be unnecessary. That parochial approach has been used in the trust accounting and not-for-profit worlds, in particular, for many years. However, I see this is beginning to change.

Treating Money as Fungible

Just like wage income vs. an investment account, the money that comes from an investment’s yield and that which comes from its capital appreciation could be considered fungible (assuming an equal tax treatment).

In other words, total return is the aggregate sum of the yield on an instrument or portfolio plus the change in market value in the form of capital appreciation or depreciation. In the case of a change in one’s personal income statement, it could be thought of as that which is coming from wages plus any cash distributed from an investment account. Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorizing an investment’s yield as flow that is eligible to be spent, while its underlying principal value is not to be liquidated for consumption.

My experience indicates that investors who want their assets to generate a return for their spending account have a bias towards investments that have a yield. Furthermore, I have found that those investors that want their assets to boost their savings account have a bias towards investments that generate capital growth.

In my opinion, there are enough investments available for both the mental spending and savings accounts. However, I do take into consideration where nominal yields are today, according to U.S. Treasury Department data. Nominal yields are so low they barely eclipse the rate of inflation, if at all, which makes their real yield negative. I believe this potentially poses a problem for those seeking to preserve their purchasing power.

In conclusion, mental accounting could potentially lead to irrational investment decisions and counterproductive outcomes. Investors might do well to think in terms of total return, not just from their investment accounts, but also savings. The financial planning process could help to identify productive and efficient ways to accumulate wealth and distribute it. It might also help to ratify a portfolio construct that suits an income need today, but rationalizes it in the context of the desire to maintain growth for the future.