By Selwyn Gerber:

certified public accountant

Chapter 10: UNDERSTANDING INVESTOR BEHAVIOR
or Why Your First Response is Likely the Wrong Investment Decision

Investors respond in “predictably irrational” ways to many situations. These self-sabotaging behaviors can be avoided if you know what to look for.

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“In investing, what is comfortable is rarely profitable.”
- Robert Arnott, investment manager

Most financial theory is based on the assumption that individuals act rationally. However, we all know from personal experience that many people react irrationally at times. Researchers have studied real people making real decisions about money and discovered that sometimes average people can indeed behave irrationally.

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An academic discipline known as “behavioral finance” has grown out of that research. Specialists in behavioral finance study individual psychology and group dynamics as they try to understand what motivates people to make financial decisions ranging from which grocery store to shop at to which stock to invest in for their retirements. Many researchers have come to believe that irrational financial decisions can actually be predictable.

Paul Slovic, a University of Oregon psychologist and an authority on how we assess risk, comes close to summarizing this body of knowledge into a single sentence, "Most people just can't think about risk in an analytic way. The average person goes by gut feelings."

There are four key findings associated with this research:

• SURVIVAL INSTINCT: The basic survival instinct that ensures success in most other endeavors in life is the result of millions of years of genetic adaptations. Unfortunately it can lead the average investor to sell at precisely the wrong time, in the midst of market panics. The typical reaction in a downturn is to panic and sell - even though the risk is actually far lower than it was when stocks were higher. When all appears gloomy and dangerous, the survival instinct drives us to action. In the markets, this is the time for inaction; sitting tight or even buying more shares during these panics can lead to profits. Likewise, it is human nature to want to join in the good times, which in the markets means buying in ebullient and booming markets, usually near the top.

• RECENCY: In everyday life, we tend to place a greater emphasis on the most recent experiences. These are the ones you think are most likely to recur in the future. We are never surprised when the weather forecast calls for the weather tomorrow to be just like it was today. In the markets, this means that we expect trends to continue. The truth is that markets roll in long sine waves and seldom in straight lines. Reversion to the mean almost guarantees that tomorrow is unpredictable, although investors believe they can simply extrapolate the recent trend.

• OVER-RELIANCE ON DATA: We are a data-centric society, and are taught to assume a correlation between the amount of data one has and the outcome. Given enough data, we believe any problem is solvable. After all it works in the design of the space shuttle. Sufficient data makes it possible to conduct successful heart transplants and minimize the chances of organ rejection. Studies and past experience have eliminated guesswork from construction of bridges, buildings and the infrastructure essential to modern society. Virtually every aspect of our lives is improved with data, except investing in equities. The famous “Dartboard Portfolio” published by the Wall Street Journal demonstrates that random selection of stocks often beats the best choices of experts.

• THE MYTH OF MEMORY: Because human beings remember well and can recall history into the present, we assume the markets too have a memory. The fact is that markets have no memory and no idea what we paid for an investment. Nor is it relevant to any decisions we make or ought to make about holding or selling. Waiting until a stock or index returns to it’s original cost before selling is a common mistake. The best approach is to ask the very basic question of oneself: “If I owned none of that today, would I buy it?” .The answer to that questions should inform and direct the course of action to be followed.

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