Investors Are Human, Too
Provided by: Duane J. Silbernagel
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 risks.
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.
Note: All investments are subject to market fluctuation, risk, and loss of principal. When sold, investments may be worth more or less than their original cost.
1 The Economist, “What’s Wrong with Finance?” May 1, 2015
2 The Wall Street Journal, “Why an Economist Plays Powerball,” January 12, 2016
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This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Waddell & Reed does not provide legal or tax advice. This information is prepared by an independent third party, Broadridge Investor Communication Solutions, Inc. and is provided for informational and educational purposes only. Waddell & Reed believes the information has been obtained from sources considered to be reliable, but does not guarantee the accuracy of the information provided. This information is not meant to be a complete summary or statement of all available data necessary for making financial or investment decisions and does not constitute a recommendation. Please consult with a tax professional regarding your personal situation prior to making any financial related decisions. Also note that the information provided may include references to concepts that have legal, accounting and tax implications. It is not to be construed as legal, accounting or tax advice, and is provided as general information to you to assist in understanding the issues discussed. Neither Waddell & Reed, Inc., nor its Financial Advisors give tax, legal, or accounting advice. Nothing contained herein is intended as a solicitation or an offer to buy or sell any product or service mentioned and they may not be suitable for all investors.
Duane Silbernagel is a Financial Advisor in Lincoln City, Oregon offering securities through Waddell & Reed, Inc., Member FINRA and SIPC. He can be reached at (541) 614-1322 or via email at DSilbernagel@wradvisors.com.
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