Investor Psychology

Be a Better Investor

Outsmart your emotions, cut your fees, keep it simple­ -- and reap higher returns.

By Bob Frick, Senior Editor

From Kiplinger's Personal Finance magazine, November 2009

Damn, it happened again. Ten years after the internet bubble ballooned, then burst, we're left to pick up our shattered portfolios from another cycle of hope, anxiety and regret. To make matters worse, our own actions added insult to the injury inflicted by the catastrophic bear market that ended last March.

By buying high and selling low, mutual fund investors, for instance, lost $42 billion more than they should have during the 12-month period that ended last May, estimates The Hulbert Financial Digest. (In a similar vein, columnist Russel Kinnel tells us that the typical investor earns far less than funds' reported returns.)

How could this have happened? The simple answer is that emotion, not logic, usually rules our investing habits. In many ways we're predisposed not just to buy high and sell low, but to cling to losing investments we should sell, ignore threats to our wealth and follow the investing herd off a cliff again and again.

These tendencies are now well documented in the burgeoning fields of investor psychology and behavioral finance. Scholars in both disciplines are arriving at a new understanding of how humans make decisions. For instance, in the bestseller Nudge: Improving Decisions About Health, Wealth and Happiness, authors Richard Thaler and Cass Sunstein say long-held assumptions that people "think like Albert Einstein, store as much memory as IBM's Big Blue and exercise the willpower of Mahatma Gandhi" are falling by the wayside. To help people, including investors, make better choices, we have to understand and embrace our emotions and predilections, say the authors, and figure out how to avoid becoming our own worst enemy.

Teachable moments

But just recognizing our mental kinks won't help us undo them, experts say. "I don't believe it's possible to change behavior that's really hard-wired into our biology," says Andrew Lo, director of the Massachusetts Institute of Technology Laboratory for Financial Engineering. But "Homo sapiens can do what we've always done: adapt. We don't have wings, but we can fly. So we develop tools to protect ourselves from these emotional shortcomings."

The silver lining to the recent bear market is that painful experiences remain in our memories for a long time and provide lessons for the future. So let's review the past few years through the eyes of experts in investor psychology and behavioral finance, studying events not as a financial roller coaster, but rather as an emotional one.

Humans are wired to organize facts around stories. The Internet bubble was fueled by a fable that the Web would lead to an unending explosion of commerce. The explosion in real estate speculation that began in the early 2000s was firmly built on the same kind of fiction. Stories of people getting rich as property prices rose year after year "replicated and spread like thought viruses," says Robert Shiller, the Yale economist who warned of the Internet and real estate bubbles in different editions of his book Irrational Exuberance. Such tales instill confidence in people and inspire them to move fast to get rich themselves.

These stories proliferate even when they fly in the face of facts. That's because we tend to look only for facts that support our story, something called confirmation bias. So, for instance, real estate prices in Las Vegas and Phoenix rose at double-digit rates, as if land in those Sun Belt cities was a scarce commodity. The desire to cash in on the property boom ignored "obvious facts," says Thaler, such as a virtually "infinite supply of land" that facilitated an abundant supply of homes.

So think back to 2006. Real estate is on fire, the stock market is doing pretty well, and both investments look like sure bets. That's about the time the dangerous psychological juju started kicking in. Greg Davies, head of behavioral finance for Barclays Wealth, the London-based financial-services giant, says investors fell victim to the recency effect and began to lose their sense of caution because they'd known nothing but gains for several years.

As a result of the recency effect, says Davies, "what's most recent in our minds stands out." For instance, "if investments have been going up for a while, I start seeing them as less risky. I start thinking, Well, my budget for risky investments isn't full -- I can put more in there."

Buying stimuli

As investors pile in and the markets continue to rise, herd behavior and regret drive our actions. One consequence of herd behavior is that it makes us think something is safe because it seems safe if everyone is doing it. And regret causes those who can't stand being left out to jump in.

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