- The Washington Times - Monday, August 23, 2004

Investors are prone to certain emotional — and often irrational — biases that affect their ability to make sound financial decisions.

In fact, there’s an increasingly popular academic establishment that is focused on exactly that: the field of behavioral finance.

“The major mistake that people make is that they are not very good at dealing with a lot of uncertainty,” said Jim Scott, a former professor at Columbia Business School and president of Quantitative Management Associates, a unit of Prudential Investment Management that manages $40 billion.

“So rather than a rational assessment of data and probabilities, they like stories and they make decisions based more on these mental images rather than a sober assessment of their portfolio and how [a particular] stock fits into it,” Mr. Scott said.

The field sprouted from the research of Daniel Kahneman and Amos Tversky, psychologists whose 1970s work on making decisions laid much of the groundwork for modern-day behavioral finance.

Indeed, Mr. Kahneman was the first psychologist to receive the Nobel Prize for economics. The Princeton psychology professor received the award in 2002 along with Vernon Smith, a professor of economics and law at George Mason University.

Today, many financial experts often draw upon the ideas pioneered by Mr. Kahneman and other academics, which demonstrate how individuals often rely on these mental shortcuts that undercut principles of probability.

It helps to explain why many folks just aren’t good at investing. “People are chasing returns and they are buying whatever the new hot product is,” said Norm Mindel, a financial planner with Genworth Financial in Schaumburg, Ill.

“People tend to first pick the investment rather than decide how the portfolio should be allocated,” he said.

One of the larger problems investors face is overconfidence. Men tend to be more overconfident than women, and men tend to trade more actively than women, which hurts their overall returns.

“People tend to think they know more than they actually do,” said Terrance Odean, a finance professor at the University of California at Berkeley.

“That’s not to suggest they shouldn’t be well-informed or confident in a strategy they develop, but they shouldn’t be lured into a false sense of security,” added John Nersesian, a wealth-management strategist at Nuveen Investments.

Investors also tend to feel more secure in their choices when following the herd, or doing what everyone else is doing.

“This is the idea that investors feel more comfortable in making financial decisions that are validated by the actions of others,” Mr. Nersesian said. “Investors become very scared if they see others heading for the exits.”

Here are a smattering of other biases and behavioral patterns:

• Recency bias: People tend to focus too much on what has happened recently. “That is true in terms of unfavorable, unsettling negative events, but it’s also true for positive events,” said Hersh Shefrin, a finance professor at Santa Clara University.

That’s also why investors will continue to buy winning asset classes — remember the tech boom? — but not sell off part of their winnings. “People tend to project recent patterns into the future,” Mr. Odean added. “There is this tendency to buy the stocks that did well last year and the mutual funds that did well last year.”

• Anchoring: Investors become married to certain reference points that influence their decisions, Nuveen’s Mr. Nersesian explained. For instance, say an investor buys a stock at $50, and it falls to $40 because the fundamentals have changed. The best thing to do might be to sell at $40. However, many people, he explained, are prone to wait for the price to recover to the $50 they are anchored against.

• Loss aversion: Investors are reluctant to realize losses, and conversely, investors are inclined to sell (sometimes too early) because they want that positive reinforcement that comes from securing a gain. “People have a tendency to hold on to their losers and sell their winners,” added Berkeley’s Mr. Odean.

• Mental accounting: The idea that we treat money differently based on the source or where we hold it. “It’s incredible how people will treat tax-return money as lottery winnings or found money,” Mr. Nersesian said.

So what’s an investor to do?

Create a formal financial plan and stick to it, but try not to get distracted by the constant stream of brokerage statements in your mailbox. Keep a long-term perspective, remain adequately diversified. Genworth’s Mr. Mindel believes investors should be in 10 or 11 different asset classes. And rebalance your portfolio.

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