Investor psychology: What you need to know before you buy or sell

By Stephen Foerster
Globe Investor Magazine Online, Oct. 16, 2008

Stephen Foerster is Professor of Finance and holder of the Paul Desmarais/London Life Faculty Fellowship in Finance at the Richard Ivey School of Business, The University of Western Ontario

It's a tough time to be investing in equities. The almost daily dose of bad news has many investors panicking and the knee-jerk reaction is to look for somewhere to run for cover. Even many seasoned investors are gripped with fear and uncertainty as to what to do.

Are the decisions we make in these troubled times always the best ones? A growing body of research into the psychological side of investing, known as behavioural finance, provides some important insights into how we make decisions and understanding this emotional side of investing may provide a financial payoff.

Traditional finance models are built on the premise that investors are rational. Any new information, say about a company's prospects for generating future cash flows, will quickly be incorporated in the stock price. In addition, investors make choices solely on the basis of what will lead to "utility maximization" or greater well-being. Nobel prize-winner Paul Samuelson was an early proponent of this school of thought and was followed by others such as University of Chicago professor Eugene Fama who coined the term "efficient market hypothesis" - essentially implying that stock prices will trade at their true fundamental value.

Countering the notion of rational behaviour, psychological experiments such as those by Amos Tversky and his Nobel-prize winning collaborator Daniel Kahneman, Hersch Shefrin and Meir Statman as well as others, show that individuals exhibit various beliefs and preferences that are consistent with a number of forms of irrationality.

Individuals tend to be overconfident in their judgments - investors may confidently predict (incorrectly) that stocks that have done well in the past will continue to do so. Most people have excess optimism and unrealistically rosy views of their abilities and prospects. In the hindsight bias, people tend to believe, after an event has occurred, that it was predictable, such observing when investors claim they "knew" a stock was going to do well. People disproportionately weight salient or memorable evidence even if they have better sources of information.

Evidence of anchoring suggests people start with some initial estimate and then adjust away from it - for example, expecting that a stock that has recently done well will continue to do so. Belief perseverance shows that once people have formed an opinion, they hold on to it for too long, implying why investors may not sell a stock that has done well in the recent past but is not doing well now. According to the bias referred to as the law of small numbers, people exaggerate how closely a small sample resembles the overall population. If investors are presented with a sample of, say, a dozen stocks that recently doubled, they may infer that most stocks double in a short period of time.

In prospect theory, investors frame their choices in terms of potential gains or losses relative to a fixed reference point. They tend to weigh a dollar loss about twice as heavily as a similar-sized dollar gain. Mental accounting suggests that investors open a mental account whenever a stock is purchased and a running score is kept relative to that price.

Regret is defined as an emotional feeling associated with the realization that a different decision would have fared better and investors may try to avoid regret by deferring realizing losses. A self-control problem is experienced by an investor who is unable to realize a loss soon enough or alternatively realizes gains too soon in order to experience pride.

There is another side to behavioural finance as well that is particularly relevant in today's market conditions. Even if a security is truly mispriced, perhaps caused by the trading actions of irrational investors, there can be limits to arbitrage.

For example, suppose you feel GM stock is undervalued while Ford stock is overvalued. There is fundamental risk in the strategy of buying GM and selling short Ford since while both firms are in the same industry their stocks are not perfect substitutes. In addition, an arbitrageur trying to exploit mispricing could find that the mispricing actually increases in the short term - a hard lesson learned by Long-Term Capital Management in the 1998 implosion of that hedge fund.

There are some important lessons we can learn from these studies.

Be aware of your own irrationality.

Don't be wedded emotionally to your investments.

Don't simply trust your gut instincts. Have a sound reason for making an investment decision and at the same time that you buy a stock think about what would cause you to sell it. And just because you feel a stock is clearly mispriced, it doesn't necessarily mean that there's a free lunch.

Special to The Globe and Mail