BEHAVIORAL FINANCE: WHY INVESTORS UNDERPERFORM THE MARKET - PART 2

By: Terry Donahe

According to the Investment Company Institute, the total assets of U.S. money market funds topped $3.5 trillions at the end of March 2008. This is a record. At the end of 2005, these funds held less than $2.0 trillion. In the past 12 months, cash in money market accounts has risen by 44 per cent.

So, what does this mean? The down draft in the financial markets that began in October of 2007 has pushed massive amounts of capital from the stock market into the safe haven of cash and money market accounts. Investors are sitting on the sidelines waiting for a strong signal that it’s time to get back in the stock market.

Behavioral finance focuses on the role that emotions and other psychological factors play in investment decisions. It identifies several human tendencies that cause investors to abandon rational thinking and result in bad decision making. In the first two parts of this series we examined Anchoring, Mental Accounting, Confirmation Bias and Hindsight Bias. Here are two more examples.

GAMBLER’S FALLACY: Many people equate investing with gambling. They view the stock market as an arena that is very much like a casino. They approach investing just as they do gambling. In the casino gamblers will behave according to their faulty beliefs about probability. If a slot machine has produced no results after numerous pulls, the gambler will often stay with the machine acting under the mistaken belief that the odds have shifted in her favor and she is that much closer to a jackpot. According to probability theory, each pull is an independent event and the odds of winning are identical with each pull. Investors will apply the same fallacy by purchasing a once strong stock that has recently fallen on hard times and lost much of its long standing value. The belief is that the stock will recover and return to its previous valuations.

HERD BEHAVIOR: Human beings are social creatures who prefer to be accepted and included by others. This tendency causes people to follow along with the group and take actions that they may well avoid if they were considering the situation in isolation. College fraternities rely on this dynamic to spur their pledges to engage in unsavory and embarrassing acts. In the investment world people often get caught up in the widespread movement toward certain kinds of investments. Whether it was the Dutch Tulip craze in the 1630s, the South Sea Company bubble of the early 1700’s or the Dot Com Crash just a few years ago, investors repeatedly display a propensity to abandon basic economic principles and follow the crowd into foolish investment decisions.

There are still more behavioral anomalies that befall investors. We’ll consider these in the next in this series of articles on Behavioral Finance. Armed with this information investors should more readily identify and avoid the poor decisions that cause so many of them to consistently underperform the market.

Terry Donahe is a CERTIFIED FINANCIAL PLANNER™ who works with affluent individuals and families. His firm, Cascade Wealth Management, is a fee only Registered Investment Advisory firm located in Lake Oswego, Oregon. You may learn more about Terry and his firm at www.cascadewealth.com. Terry can be reached at (503)675-4381 or by email at terry@cascadewealth.com.

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