Market Minute - July 17, 2017
by Scott Rosenquist, CFA
Traditional finance is built on the premise that investors are rational and will make optimal decisions regarding investments. It relies heavily on financial market theories and the relationship between risk and return. Behavioral finance, on the other hand, acknowledges that people are the ones interacting in the financial markets and may not always act rationally or make optimal decisions. Behavioral finance introduces the idea of biases that investors exhibit and how they can affect decision making. I find this topic very interesting and wanted to introduce it by highlighting one of these behavioral biases. I plan on discussing others in future market minute posts.
Most investors would consider themselves risk-averse in a situation where two investments have similar expected returns, but one of them comes with additional risk. A rational investor would select the less risky investment or show risk aversion. Loss aversion is a behavioral bias where a person places more “value” on a loss compared to a gain. In other words, the negative feeling of taking a loss is greater than the positive feeling of a gain. This can be seen when a person holds onto a poor performing investment waiting for it to turn around instead of selling and realizing the loss. It may lead to risk-seeking behavior in order to avoid taking a loss. The rational thing to do would be to evaluate the investment to see if something fundamentally has changed. If that means taking a loss, then that would potentially be an optimal decision and allow the proceeds to be deployed another way.
Behavioral biases are present in almost all decisions especially those that are financial in nature. It is important to recognize them and seek out ways to minimize their effects. Being aware of tendencies and biases and how they can affect the decision making process can help create opportunity to address them and may even increase the chance of meeting long-term financial needs.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and/or opinions are revealed, this post is not intended to nor does it represent or reflect transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.