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| In Practice: Patterns of Investor Irrationality |
| by
Jim Licato and Alina Tarlea
| 10-15-09 |
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Here are some common ways issues of behavioral finance show up in practice.
The Melting Pot
Despite the recent runup in the stock market, it is safe to assume that investors are still a bit hesitant to get back into the market (or to stay in the market), let alone consider the riskiest of investments. What investors should understand is that separate types of investments perform differently from one another, which has made it possible to lower the risk of volatile assets by combining them with other types of investments. (View the related graphic here.)
Mental accounting is a pattern of investor irrationality in which an investor mentally compartmentalizes investments while neglecting to focus on the portfolio as a whole. Mental accounting can often impede investors from making sound financial decisions.
This investor behavior is often evident when international investments are introduced. Risks that often raise red flags when investing internationally include currency, economic, political, and market liquidity. When clients view this particular investment in a vacuum, they are usually less receptive to include it in their portfolios. They are dismissing the potential diversification benefits of international investments and possible improvements in the risk/return trade-off.
While the relative safety of cash and bonds may be soothing, especially during this day and age, investors are sacrificing long-term growth. Some investors may be willing to sidestep greater returns because the volatility of stocks may be too intimidating. As shown in the table, by focusing on the whole portfolio (and not just the individual components), an investor would actually experience a risk level that was lower than bonds and a return that was comparable to stocks.
It is important to note that some mental accounting may be helpful for your clients. For example, if it is helpful for them to mentally account for investments in terms of the goals they are trying to achieve (retirement, college savings, etc.), mental accounting could be warranted. In most cases, however, where your clients are reluctant to get back into the market, or to just stay the course, having them concentrate solely on the total portfolio may help pacify them.
Short-Term Focus
It's tempting for clients regularly to monitor their investment accounts. Instant access to real-time quotes and a barrage of media reports on daily stock market fluctuations can make it difficult for clients with a long-term investment horizon to stay focused on their goals. In reality, these daily market movements may not be as extreme as they seem. As investors look longer term, their perception often changes. (View the related graphic here.)
Short-term market fluctuations can be quite volatile, and the probability of realizing a loss within any given day is high. However, the likelihood of realizing a loss has historically decreased over longer holding periods. The graph illustrates that while the probability of losing money on a daily basis over the past 20 years was 46%, the probability dropped dramatically to 25% when analyzing an annual time period.
Periodic review of an investment portfolio is necessary, but investors shouldn't let short-term swings affect their view of the future.
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