Many modern financial theories assume market participants are rational and make decisions based on information and empirical evidence rather than with emotions, however, this is often not the case.
Joshua P. Preiss, CFA®
Aug. 19th, 2018
This article will seek to explain several common behavioral biases investors hold, and the potential impact they have on investor decisions.
Price anchoring is the concept of making investment decisions based on the purchase price of an asset rather than the asset’s current expected return. Often, investors will hold onto an asset because they do not want to sell at a loss, even if the likelihood of the asset generating satisfactory returns is lower than investing elsewhere.
For example, an investor may choose to hold onto a stock trading at $45 because they paid $50 for it and do not want to sell the asset below the price paid. If the investor believes the original investment thesis on the company is still intact and the current price repression is a short run loss, they should hold onto the stock or double down and purchase more of the asset, because the expected return is now higher than it initially was at a price of $50. If, however, the price repression is a result of material new information about the company, and the price of $45 is justified, the expected return on the asset becomes 0%. In this case, the investor will likely be better off selling the asset and buying an asset with a positive expected return, even if they have to sell at a 10% loss.
Herding and Social Validation
Herding refers to the tendency for investors to herd together and buy and sell assets based on what other market participants are doing rather than the underlying economic fundamentals of the asset. Herding is often caused by investors seeking social validation and following what others are doing for fear of sticking out from the pack. When investors herd together and invest based on what others are doing rather than based on the intrinsic value of assets, price distortions can form in markets.
A commonly cited example of herding was the dotcom bubble of the early 2000’s. At the time many market participants invested in stocks with any link to the internet or technology, regardless of the underlying fundamentals or growth prospects of the company. A root cause of this herding behavior was the belief that if everyone else was making these investments, there was a lowered probability of the investment turning out poorly.
Similarly, this tendency for investors to herd together and use the behavior of others as a guidepost was a contributing factor in the 2008 financial crisis, with investors pouring trillions of dollars into Mortgage Backed Securities, Collateralized Debt Obligations and exotic derivative instruments on these securities. During this time investors believed that because other market participants were investing in these assets, it made them a safe investment with high returns and low risk. However, some hedge fund managers diverged from the crowd and focused on the underlying economic fundamentals of these assets, and were able to make fortunes off shorting these assets by exploiting price inefficiencies created by herding behavior in the market.
A final common bias in markets is the tendency for investors to overreact to non-material information, as well as for investors to make investment decisions based on short-term market volatility.
First, investors may overreact to rumors about a company or to new information on a company which does not have a bearing on the long run value of the firm. Especially in today’s 24/7 news cycle and the constant stream of information on social media, it is common for investors to trade stocks based on headlines rather than on company fundamentals or business models.
On an individual investor level, a common overreaction is making investment decisions based on short run volatility. Oftentimes investors will panic when market volatility increases, and pull their money from the market at inopportune times, harming their long run portfolio returns by reacting to short run price fluctuations. Many investors pulled their money from the stock market during the depths of the financial crisis and remained uninvested until well after the recovery in asset prices occurred. According to Morningstar, the S&P 500 has generated a total return of 274.84% from February 27, 2009 to August 13, 2018. This means if an investor held an ETF which tracked the S&P 500 and sold it in February of 2009 due to concerns over market volatility, they potentially missed out on 270% of investment returns they could have received if they had held onto the asset. This example shows the importance of sticking to a disciplined investment strategy and not making emotional decisions based on short run volatility.
Please contact us if you have any questions regarding this topic.
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