David Ollech has leveraged his entrepreneurial skills to support ventures in a range of different industries, including businesses operating in the agri-nutrition and forestry markets. This article will look at the psychology of investing, providing an overview of key factors that influence investor behaviour.
When it comes to investing their money, people can sometimes act in unpredictable and even irrational ways. Mainstream financial theory centres around the premise that market participants will act rationally. However, behavioural finance challenges the assumptions of the rational actor theory as it applies to investments, markets and other financial matters. Drawing heavily on cognitive psychology, behavioural finance is utilised to better understand investor behaviour in the real world.
Forming the crux of the efficient market hypothesis, the rational actor theory surmises that investors rely completely on rational calculations, making rational choices that culminate in outcomes aligned with their best interests, a concept known as ‘utility maximisation’. The rational actor theory supposes that rational actors make rational choices based on error-free calculations, having accessed full and complete information. The goal of rational actors is to maximise their advantage by consistently minimising losses in a self-interested manner.
Nevertheless, research suggests significant flaws with the rational actor theory, with uncovered evidence revealing that, in reality, rational behaviour is not as prevalent as once presumed in mainstream economics. Behavioural finance is a field that investigates the power of human emotions to sway investment decision-making processes, and researchers have published some surprising findings.
Dalbar is a financial services research firm that publishes an annual Quantitative Analysis of Investor Behaviour study. In the 2015 edition, the report concluded that, on average, investors consistently failed to achieve returns that exceeded or even matched the broader market indices. Rather, the report revealed that equity mutual fund investors typically underperformed the S&P 500 by a substantial 8.19% margin. Dalbar’s report revealed that the broader market return was more than double returns generated by the average equity mutual fund investor. The report also suggested that the typical fixed income mutual fund investor consistently underperformed, returning less than the average bond market index return of 4.81%.
In 2020, Dalbar published a follow-up report, concluding that investors once again failed to achieve market-index returns. The report revealed that, on average, equity investors earned 5.35% less than returns generated by the S&P 500. In addition, although fixed-income investors had seen their best annual gains since 2012 at an average of 4.62%, this was still lower than the benchmark index return of 8.72%.
Fear of regret is a concept that explores the emotional reaction an individual experiences after realising they have made an error in judgement. Faced with the prospect of selling stock, investors can be emotionally affected by the price they paid for it. Fear of regret may motivate them to avoid selling as a means of avoiding having to face up to the fact that they made a poor investment decision, as well as saving them the embarrassment of reporting a loss.
However, experts suggest that what investors really need to consider when contemplating a sale of stock is whether they would repeat the same purchase if the security were already liquidated. Would they choose to invest in it again? If the answer is no, this is a clear indication that the time has come to sell. Otherwise, the investor will face not only the regret of purchasing a losing stock but also come to rue their decision to hold on to it. Thus, this scenario effectively turns into a vicious cycle where the attempt to avoid regret only leads to more regret.
To be successful, investors must isolate their emotions to avoid their feelings clouding investment decisions. While humans excel at disguising emotional choices as respectable logic, it is crucial for investors to look at scenarios objectively, taking their time with decisions, cross-analysing why they chose that path and following through with their choices.
