Most economic theories are based upon the assumptions that human beings act rationally and will look for ways to maximize their utility 100% of the time. For decades psychologists and sociologists have pushed back against this belief and have a wide range of data suggesting systematic irrational behaviour among human beings.
Behavioural finance asserts that rather than being completely rational and calculated at all times, that human beings often make financial decisions based upon emotions and cognitive biases. Two common biases we see as advisors all the time that we need to help coach clients with include “Loss Aversion” and “Herd Mentality”.
Investors will often hold losing stocks rather than feel the pain associated with selling for a loss. This is a result of loss aversion. Loss aversion is a cognitive bias and a concept associated with “Prospect Theory” developed by Daniel Kahneman and Amos Tversky. It is believed that the emotional pain of losing is about twice as powerful as the pleasure we receive from a gain. This would explain why an investor might have a hard time locking in an official loss with a clearly losing investment, despite having a better opportunity right in front of them. It would also help explain why some investors have such knee-jerk reactions anytime a stock goes down in value, yet are willing to hold an investment that may be overpriced. Emotionally, we just feel the losses so much more.
Herd mentality is driven by the fact that investors feel most comfortable going with the crowd rather than being the odd one out. This is why we see investors throw money at investments when markets are reaching all-time highs and avoid stocks altogether when markets sell-off, despite it being the best time to buy. The cycle of greed and fear in the market is a direct result of this herd mentality. It’s not entirely our fault either. In the animal kingdom, creatures of all sorts band together to feed, fend off enemies, and migrate. Moving as a herd is an instinct that has served our survival needs well since our time as hunters and gatherers. Unfortunately with investing, this characteristic doesn’t serve us nearly as well and is seldom a lucrative strategy over the long term. The tricky thing with herds is predicting when the herd will change its mind.
An Apple Case Study
Investors who purchased Apple in October of 2018 would have watched their investment decline 30% over the next 3 months. The phone maker missed analysts’ “expectations” and at the same time declared that they will no longer be providing unit sales data for the iPhone moving forward. Investors who let loss aversion or herd mentality get the best of them sold one of the best companies in the world at what has proved to be a terrible price (as of writing this Apple became the first company to reach a $3 trillion valuation). Investors who bought and held would have earned 216% if they still owned the position today.
So how as investors can we combat these two biases and protect ourselves from the damage they can cause?
With herd mentality, it’s helpful to determine what investment strategy makes the most sense to you and stay disciplined to that strategy. Avoid what others are saying and how much money they may be making. A long-term strategy that you stay disciplined to will yield better results than trying to figure out where the herd is going or chasing the flavour of the week.
When it comes to loss aversion, a helpful strategy is to clearly define the rules you will use when you buy or sell a stock, and then stick to those rules. This will avoid letting the emotional power of the loss crowd your judgment. At Endeavour, we never sell a stock just because it’s gone down in value. As we saw from the Apple example, selling a stock because it went down in value is a terrible way to make an investment decision. We sell a stock either because our thesis around the stock has fundamentally changed (we were either wrong or something unexpected has caused the thesis to change) or when there is a company we’ve determined is just a better investment opportunity.
Loss aversion and herd mentality are only two of the many behavioural traits that cause investors to make irrational investment and financial decisions. I find the psychology of investing fascinating and an area that seems to not be given as much attention as it should. Throughout 2022 (and likely beyond), I look forward to sharing more information on behavioural finance and how you can use the psychology of investing to provide you with a sustainable advantage over the majority of investors out there.
- Brandt Butt, Investment Advisor, CIM®
Brandt is an Investment Advisor and part of an award-winning team at Endeavour Wealth Management with iA Private Wealth. Brandt’s focus is working with incorporated physicians and dentists between the ages of 35-45 who are looking to set themselves up on the right financial path in hopes of reaching a point where they are choosing to work, instead of having to.
Brandt’s team delivers value through advanced financial planning solutions for incorporated professionals while working closely with their accounting and legal professionals. By doing so, Brandt’s clients’ situations are optimized which can save them hundreds of thousands in taxes each year allowing them to grow their net worth faster with the goal of reaching complete financial independence.
This information has been prepared by Brandt Butt who is an Investment Advisor for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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