Emotions in Personal Finance
A Westmont College-hosted talk in February by Nobel Prize winner Daniel Kahneman spoke to the increasing awareness of behavioral economics. Kahneman won the prize in 2002 for his creation of the prospect theory: the concept that investors feel the pain of losses much more than the joy of gains. This echoed a similar sentiment from Adam Smith 200 years earlier but overturned the ruling theory of economics at the time – that humans act rationally in economic decisions.
The fascinating results of the prospect theory have reshaped financial thought and provided some good lessons for investors. Since the pain of loss is twice as pronounced as the satisfaction of gain, Kahneman finds that our actions are dictated by loss aversion. That is, we engage in risky behaviors to avoid the reality of a loss. As investors, the most obvious example is when we routinely sell stocks that have risen to lock in a gain and conversely when we hold losing stocks to avoid the reality of a loss. The cure for this particular damaging behavior is to remove the emotion and for investors to weigh each decision on economic merit.
Anchoring, the concept that we make economic choices influenced by data that is irrelevant, is another emotional behavior that causes problems for investors. For most of us, this bias shows up with recent information. For example, the price we paid for an investment often outweighs the potential return of an investment when it comes to action – if we pay $50 for something, many of us will be loath to sell it for less even if it eventually becomes worthless. One way to mitigate this bias is to pretend you don’t already own the investment and ask yourself if you would purchase it at this price with cash. If not, you are likely holding it for non-economic reasons.
Another bias, availability bias, is especially appropriate in the information age when we face a deluge of information on every topic. Studies have found that we tend to latch on to the information that has the most impact or is the most recent. For years after 2008 stock market meltdown, researchers found that a majority of respondents said the market was flat or down in 2009 and 2010, even though it was up 40% during those years. This skew of taking recent negatives (and positives) and extrapolating forward often leads to missed opportunities and poor decisions – think cryptocurrency and cannabis as well. Here the most common cure is to put everything in context: the newest information or great story is just one data point amongst many for your successful and rational decisions.