Geopolitical events. Elections. Fear of a recession. Panics.
Any one of these is enough to keep the average investor on edge with an itchy buy/sell trigger finger. But a growing number of psychological and financial theories called “behavioral finance” is showing that during uncertain times, it’s more important than ever to rely on available data and put aside emotion-fueled investing.
This field of research, which marries economics with biology and psychology, studies certain types of investing decisions—including those made on emotional or speculative grounds, often made hastily without all the facts or because of what others are doing.
Prior to the development of behavioral economics, in the early 1960s economists tended to believe that people behave logically, aiming to maximize value in coldly calculated terms. Over time, however, a growing body of evidence has led researchers to suggest otherwise: People don’t always think rationally. For investors, that can lead to poor decision-making and adverse portfolio outcomes.1
In determining how emotions come into play, it’s important to recognize how investors react to short-term changes. Behavioral finance theory identifies a number of behaviors that investors typically fall prey to. These include:
- Herding, or following the crowd, is the tendency to flock into the same sectors or markets that others are gravitating toward.
- Anchoring is when investors are slow to react to economic, corporate or market developments because of an irrational attachment to a perceived value, even in the face of changing information.
- Recency bias involves investors believing that recent events will continue. If the markets have been up, some investors project that forward, though there may be no fact-based data to back up that premise.
- Regret aversion is the natural desire to avoid regretting a decision. This regret may grow in proportion to an investor’s perceived responsibility and the scale of any potential negative consequences.2
- Loss aversion describes how investors may weigh losses as being more painful than gains are pleasurable, potentially leading them to overvalue losses and take too little risk.3
These types of behaviors explain why many investors tend to buy stocks after a long rally and sell after a long or sharp decline.
Fortunately, behavioral finance theory can be used to help investors develop a greater understanding of how their minds work and to show them that their investment decisions shouldn’t be driven by emotion, but rather by a coherent strategy. The goal is not to make them smarter, but to make them aware of basic human psychological shortcomings so they are less likely to undertake counterproductive actions. Or—at the very least—not to make snap judgments every time there is a potential trigger incident.
A good way to combat these kinds of knee-jerk decisions is to slow down thinking and calmly assess the facts. Another tool is to rely on someone who can look at markets with clarity. A Financial Advisor can help filter your decisions, sounding the alarm on any that appear to be irrational. But for that to work, it requires candor about your priorities, both short- and long-term.
Having a concrete plan for investments removes some of the emotion and may help you stay focused on what truly matters to you.
Finally, it’s worth mentioning that it’s a mistake to assume that only novice investors can fall prey to poor decision making when it comes to investments. Even among sophisticated investors, once emotion takes hold, anyone can make irrational decisions. Biases affect everyone, because, in the end, we are all human.
Work with your Morgan Stanley Financial Advisor to plan a detailed investment strategy that can help you achieve your goals.