Investors Are Human, Too
In 1981, the Nobel Prize-winning economist Robert Shiller
published a groundbreaking study that contradicted a prevailing theory that
markets are always efficient. If they were, stock prices would generally mirror
the growth in earnings and dividends. Shiller's research showed that stock
prices fluctuate more often than changes in companies' intrinsic valuations
(such as dividend yield) would suggest.1
Shiller concluded that asset prices sometimes move
erratically in the short term simply because investor behavior can be
influenced by emotions such as greed and fear. Many investors would agree that
it's sometimes difficult to stay calm and act rationally, especially when
unexpected events upset the financial markets.
Researchers in the field of behavioral finance have studied
how cognitive biases in human thinking can affect investor behavior.
Understanding the influence of human nature might help you overcome these
common psychological traps.
Individuals may be convinced by their peers to follow
trends, even if it's not in their own best interests. Shiller proposed that
human psychology is the reason that "bubbles" form in asset markets. Investor
enthusiasm ("irrational exuberance") and a herd mentality can create excessive
demand for "hot" investments. Investors often chase returns and drive up prices
until they become very expensive relative to long-term values.
Past performance, however, does not guarantee future
results, and bubbles eventually burst. Investors who follow the crowd can harm
long-term portfolio returns by fleeing the stock market after it falls and/or
waiting too long (until prices have already risen) to reinvest.
This mental shortcut leads people to base judgments on
examples that immediately come to mind, rather than examining alternatives. It
may cause you to misperceive the likelihood or frequency of events, in the same
way that watching a movie about sharks can make it seem more dangerous to swim
in the ocean.
People also have a tendency to search out and remember
information that confirms, rather than challenges, their current beliefs. If
you have a good feeling about a certain investment, you may be likely to ignore
critical facts and focus on data that supports your opinion.
Individuals often overestimate their skills, knowledge, and
ability to predict probable outcomes. When it comes to investing,
overconfidence may cause you to trade excessively and/or downplay potential
Research shows that investors tend to dislike losses much
more than they enjoy gains, so it can actually be painful to deal with
financial losses.2 Consequently, you might avoid selling an
investment that would realize a loss even though the sale may be an appropriate
course of action. The intense fear of losing money may even be paralyzing.
It's important to slow down the process and try to consider
all relevant factors and possible outcomes when making financial decisions.
Having a long-term perspective and sticking with a thoughtfully crafted
investing strategy may also help you avoid expensive, emotion-driven mistakes.
All investments are subject to market fluctuation, risk, and
loss of principal. When sold, investments may be worth more or less than their
The Economist,"What's Wrong with
Finance?" May 1, 2015
The Wall Street Journal,"Why an
Economist Plays Powerball," January 12, 2016