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On the Psychology of Investing [Book Review]
By Peter Benedek, PhD CFA
Founder: www.RetirementAction.com
Some of the pioneers of behavioral finance are Drs. Kahneman, Twersky and Thaler. This short introduction to the subject is based on John Nofsinger’s little book entitled “Psychology of Investing” an excellent quick read for all medical professionals or anyone who is interested in learning more about behavioral finance.
Rational Decisions?
Much of modern finance is built on the assumption that investors “make rational decisions” and “are unbiased in their predictions about the future”, however this is not always the case.
Cognitive errors come from (1) prospect theory (people feel good/bad about gain/loss of $500, but not twice as good/bad about a gain/loss of $1,000; they feel worse about a $500 loss than feel good about a $500 gain); (2) mental accounting (meaning that people tend to create separate buckets which they examine individually), (3) Self-deception (e.g. overconfidence), (4) heuristic simplification (shortcuts) and (4) mood can affect ability to reach a logical conclusion.
John Nofsinger’s Book
The following are some of the major chapter headings in Nofsinger’s book, and represent some of the key behavioral finance concepts.
Overconfidence leads to: (1) excessive trading (which in turn results in lower returns due to costs incurred), (2) underestimation of risk (portfolios of decreasing risk were found for single men, married men, married women, and single women), (3) illusion of knowledge (you can get a lot more data nowadays on the internet) and (4) illusion of control (on-line trading).
Pride and Regret leads to: (1) disposition effect (not only selling winners and holding on to the losers, but selling winners too soon- confirming how smart I was, and losers to late- not admitting a bad call, even though selling losers increases one’s wealth due to the tax benefits), (2) reference points (the point from where one measures gains or losses is not necessarily the purchase price, but may perhaps be the most recent 52 week high and it is most likely changing continuously- clearly such a reference point will affect investor’s judgment by perhaps holding on to “loser” too long when in fact it was a winner.)
Considering the Past in decisions about the future, when future outcomes are independent of the past lead to a whole slew of more bad decisions, such as: (1) house money effect (willing to increase the level of risk taken after recent winnings- i.e. playing with house’s money), (2) risk aversion or snake-bite effect (becoming more risk averse after losing money), (3) trying to break-even (at times people will increase their willing to take higher risk to try to recover their losses- e.g. double or nothing), (4) endowment or status quo effect (often people are only prepared to sell something they own for more than they would be willing to buy it- i.e. for investments people tend to do nothing, just hold on to investments they already have) (5) memory and decision making ( decisions are affected by how long ago did the pain/pleasure occur or what was the sequence of pain and pleasure), (6) cognitive dissonance (people avoid important decisions or ignore negative information because of pain associated with circumstances).
Mental Accounting is the act of bucketizing investments and then reviewing the performance of the individual buckets separately (e.g. investing at low savings rate while paying high credit card interest rates).
Examples of mental accounting are: (1) matching costs to benefits (wanting to pay for vacation before taking it and getting paid for work after it was done, even though from perspective of time value of money the opposite should be preferred0, (2) aversion to debt (don’t like long-term debt for short-term benefit), (3) sunk-cost effect (illogically considering non-recoverable costs when making forward-going decisions). In investing, treating buckets separately and ignoring interaction (correlations) induces people not to sell losers (even though they get tax benefits), prevent them from investing in the stock market because it is too risky in isolation (however much less so when looked at as part of the complete portfolio including other asset classes and labor income and occupied real estate), thus they “do not maximize the return for a given level of risk taken).
In building portfolios, assets included should not be chosen on basis of risk and return only, but also correlation; even otherwise well educated individuals make the mistake of assuming that adding a risky asset to a portfolio will increase the overall risk, when in fact the opposite will occur depending on the correlation of the asset to be added with the portfolio (i.e. people misjudge or disregard interactions between buckets, which are key determinants of risk).
This can lead to: (1) building behavioral portfolios (i.e. safety, income, get rich, etc type sub-portfolios, resulting in goal diversification rather than asset diversification), (2) naïve diversification (when aiming for 50:50 stock:bond allocation implementing this as 50:50 in both tax-deferred (401(k)/RRSP) accounts and taxable accounts, rather than placing the bonds in the tax-deferred and stocks in taxable accounts respectively for tax advantages), (3) naïve diversification in retirement accounts (if five investment options are offered then investing 1/5th in each, thus getting an inappropriate level of diversification or no diversification depending on the available choices; or being too heavily invested in one’s employer’s stock).
Representativenes may lead investors to confusing a good company with a good investment (good company may already be overpriced in the market; extrapolating past returns or momentum investing), and familiarity to over-investment in one’s own employer (perhaps inappropriate as when stock tanks one’s job may also be at risk) or industry or country thus not having a properly diversified portfolio.
Emotions can affect investment decisions: mood/feelings/optimism will affect decision to buy or sell risky or conservative assets, even though the mood resulted from matters unrelated to investment. Social interactions such as friends/coworkers/clubs and the media (e.g. CNBC) can lead to herding effects like over (under) valuation.
Financial Strategies
Nofsinger finishes with a final chapter which includes strategies for:
(i) beating the biases: (1) Understand the biases, (2) define your investment objectives, (3) have quantitative investment criteria, i.e. understand why you are buying a specific investor (or even better invest in a passive fashion), (4) diversify among asset classes and within asset classes (and don’t over invest in your employer’s stock), and (5) control your investment environment (check on stock monthly, trade only monthly and review progress toward goals annually).
(ii) using biases for the good: (1) set new employee defaults for retirement plans to being enrolled, (2) get employees to commit some percent of future raises to automatically go toward retirement (save-more-tomorrow).
Assessment
Buy the book (you can get used copies through Amazon). As indicated it is a quick read and occasionally you may even want to re-read it to insure you avoid the biases or use them for the good. Also, the book has long list of references for those inclined to delve into the subject more deeply.
You might even ask “How does all this Behavioral Finance coexist with Efficient Market theory?” and that’s a great question that I’ll leave for another time.
More: SSRN-id2596202
Conclusion
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Filed under: "Ask-an-Advisor", Accounting, Book Reviews, Experts Invited, Interviews, Investing, Marcinko Associates, Portfolio Management, Retirement and Benefits | Tagged: behavioral economics, behavioral finance, Kahneman, Marcinko, Peter Benedek, Psychology of Investing, Thaler, Twersky, www.RetirementAction.com |
The Leading Business Education Network for Doctors, Financial Advisors and Health Industry Consultants 
Retirement Planning
From a behavioral economics point of view, the field of financial advice is quite strange and not very useful. For the most part, professional financial services rely on clients’ answers to two questions:
• How much of your current salary will you need in retirement?
• What is your risk attitude on a seven-point scale?
From the perspective of Dan Ariely PhD, who does research in behavioral economics, these are remarkably useless questions — but we’ll get to that in a minute.
First, he asks us to think about the financial advisor’s business model. An advisor will optimize your portfolio based on the answers to these two questions. For this service, the advisor typically will take one percent of assets under management – and he will get this every year!
Not to be offensive, but Dan and I think that a simple algorithm can do this, and probably with fewer errors. Moving money around from stocks to bonds or vice versa is just not something for which we should pay one percent of assets under management.
Actually, strike that. It’s not something we should do anyway, because making any decisions based on answers to those two questions don’t yield the right answers in the first place. Here’s why, according to Dan?
Link: http://danariely.com/2011/08/30/asking-the-right-and-wrong-questions/
Dr. David Edward Marcinko MBA
http://www.CertifiedMedicalPlanner.com
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Errors in Human Behavior and Finance
An interesting essay for ME-P readers.
http://moneywatch.bnet.com/investing/blog/wise-investing/the-behavior-of-individual-investors-to-err-is-human/3022/?tag=col1;blog-river
Chad
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Behavioral Finance,
Peter – Research from Dr. James Prochaska and his colleagues in the field of psychology suggests that the process of changing behavior – whether with respect to eating healthier, exercising more, ending a smoking habit, or making better financial decisions – is greatly nuanced. Not only does it often take more than just one dose of good advice to bring about significant and lasting behavior change, but just because someone has a meeting with a professional does not necessarily mean that person is really even ready for change in the first place.
Accordingly, an ideal process for FAs working with physician clients may entail first understanding what stage of change they are in [fear, uncertainty doubt, euphoria, greed, etc], and then adapting the advice process to help the doctor move forward, from wherever he/she is at the time.
Dr. David Edward Marcinko MBA
http://www.CertifiedMedicalPlanner.org
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Unless You Are Spock, Irrelevant Things Matter in Economic Behavior
According to RICHARD H. THALER PhD, people are not as rational as economists would like to believe, but there are ways to nudge people into doing what’s best for them.
Garner
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Understanding Behavioral Aspects of Financial Planning and Investing
Journal of Financial Planning, Volume 28, Issue 3, pp. 22-26
Abstract:
Understanding fundamental human tendencies can help financial planners and advisers recognize behaviors that may interfere with clients achieving their long-term goals. The authors describe several well-established behavioral biases and suggest how to overcome them.
Click to access ssrn-id2596202.pdf
Hope R. Hetico RN MHA CMP™
http://www.CertifiedMedicalPlanner.org
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