The Psychology of Investing

The fourth part in a series about the cognitive biases and psychological influences that impact investing.

Throughout this behavioral finance series, Janney’s Chief Investment Strategist Mark Luschini has offered some of the key principles surrounding the psychology of investment decision-making, especially under conditions of risk and uncertainty. He has also focused on the practical ways investors could mitigate the risks that behavioral biases pose for portfolios. These practices include discipline, goal-setting, and thorough planning with the assistance of a Financial Advisor.

In this installment of the Behavioral Finance and Investment Principles series, readers can learn about three more behavioral biases: endowment effect, sunk-cost fallacy, and illusion of control.

Endowment Effect

The endowment effect describes a bias in which an individual believes something they own is worth more than what others think it is worth.^*

This tendency is not, however, to be interpreted as the owner’s reluctance to sell. Rather, the owner is more apt to sell the item when a buyer meets or exceeds the value the owner has placed on it. This occurs even if the owner receives an offer from a buyer who has reasonably valued the item in comparison to those similar on the marketplace.

Certainly, the owner might have established an emotional significance to the item. In my opinion, this could lead to a circumstance in which the owner places an artificial value on an item that is higher than what they would pay for the same item if they did not own it.

The key psychological reason behind this cognitive bias is “ownership”—the item “belongs” to the person. I suggest investors consider how the endowment effect can influence their investment decision-making. For example, consider a situation in which they impute a higher value to the stock they own in a particular company without using reasonable measures.

They may further deflect concerns about the company’s deteriorating fundamentals as misplaced—absorbing only the information that reinforces their view that the stock is worth more than its current price. The danger in this example is overlooking the variables that could impart a negative impulse on the stock.

To mitigate the risks of the endowment effect, investors could apply an objective approach to assessing the value of a security, portfolio, or the stock market. A Financial Advisor could help to contextualize the value in question by providing benchmarks, peer analysis, and third-party reviews as a means of establishing a reasonable and unemotional appraisal of what an item is worth. This approach has the potential to help individuals maintain objectivity and not let personal feelings get in the way of making money.

Sunk-Cost Fallacy

A sunk cost is one in which the expense associated with the purchase of an item has already been spent. The sunk-cost fallacy^† can motivate someone to do something based on how much money they have already invested.

In theory, what was paid should not be relevant to future decisions about what to do with the item purchased. Of course, in circumstances where capital gains could be generated, the cost basis may matter to the holding period of the purchase and whether it would be a taxable event. Having said that, the theory still applies because many investors might face the consequences of decisions that were based on investment cost as opposed to what it is worth today and, perhaps more importantly, what are its prospects going forward.

In regards to investing, the sunk-cost effect is manifested in a few ways. One finds that people are inclined to invest beyond the initial outlay even when it is not working out well, or is losing value. The common refrain that matches this tendency is “chasing good money after bad.” Investors unwilling to admit that a mistake has been made may hold on to a stock far too long even as it has failed to fulfill its promise, perhaps missing better opportunities along the way.

Another fallacy of the sunk-cost theory is looking at the value of an investment and making the decision to buy more, hold it, or sell it based on the original purchase price. When asked by an investor about my opinion on what course they should take, I respond by suggesting they analyze the existing investment as if they did not own it. Would they choose the same investment again?

Obviously, this re-evaluation begs the question as to whether the investment offers as good, or better, upside potential than another investment. If the conclusion is that it does not, then the investment could likely be sold and the proceeds deployed for purchase in one with potentially better prospects.

A Janney Financial Advisor could help walk an investor through this assessment, accounting for the myriad variables that might influence a buy-or-sell decision. They may enrich the evaluation process by providing supporting materials that offer various perspectives. In addition, an advisor could enhance the decision-making process by separating the cost from the item’s current and potential values.

Illusion of Control

The illusion of control^‡ is the cognitive tendency to believe that one has more control over an outcome than they really do.

This might be a perception that an unfortunate event could have been predicted, or avoided completely, if a different choice was made about something prior to the outcome. In my experience, illusion of control is problematic when it comes to investing.

An example I offer would be the purchase of a stock with attractive fundamentals and good long-term prospects that encounters a sizable decline in value or generates little or no return because of a subtle regulatory change. An investor in this company might be surprised by the stock’s poor performance due to such issue. In this case, the illusion of control could convince the investor that if they knew that one extra detail, it would have made their decision different and potentially led to a better outcome.

Thus, it reinforces the bias that the next time that investor will almost certainly make a better decision because they believe they will know more about what to consider when evaluating an existing position or a new purchase. This could also lead to blaming oneself for having made an error, which could paralyze the ability to make future decisions.

Investment decisions are often made without the entire breadth of information one is capable of gathering. Client-advisor discussions might help to emphasize that decisions are often more about calculated probabilities than definitive outcomes.

In addition, I believe having an investment thesis before making a purchase, while understanding there are variables that could undermine its success, may allow more cognitive flexibility. While conviction in support of an investment thesis is important to combat the traps that can befall investors who succumb to useless noise, dogma could also hurt the portfolios of those who fail to acknowledge new and unpredictable information.