We are not as rational as we think we are. When it comes to money and investing, people do some pretty strange things. Ever wonder why we do the things we do with our portfolios? Well, there's a whole field of study that explains our sometimes-strange behavior. Where do you fit in? Much of the economic theory available today is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process. This goes hand in hand with the efficient market hypothesis. In fact, researchers have uncovered evidence that rational behavior is not often the case. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision making process. Prospect theory It doesn't take a brain surgeon to know that people are risk averse and prefer a sure investment return rather than an uncertain one. We want to get paid for taking the extra risk. That's pretty reasonable. Here's the strange part. Prospect theory suggests people react differently to equivalent situations depending on whether it's presented as a gain or a loss. Individuals get more stressed out by prospective losses than they are happy by equal gains. Sounds silly, but true. You'll never hear an investment advisor tell you she got flooded with calls because she reported, say, a $500,000 gain in a client's portfolio. But, you can bet that phone will ring when a similar report posts a $500,000 loss! A loss always appears larger than a gain of equal size. It's funny how when it goes deep into our pockets, the whole perspective changes. How many times have you held onto a losing stock because you couldn't bring yourself to sell it at a loss? People end up taking more risks to avoid losses than to realize gains. Gamblers on a losing streak behave in a similar fashion, doubling up bets to try and recoup what they-ve already lost. By having the following misconception, "I know the stock price will bounce back, then I'll sell it", investors pile on more risk to avoid realizing a loss. If these seem like inconsistent attitudes toward risk, well, they are! What we find is people set a higher price on something they own than they would normally be prepared to pay.
An alternative to the loss aversion theory is that investors might choose to hold their losers and sell their winners because they believe that today's losers may soon outperform today's winners. Investors often make the mistake of chasing the action by investing in stocks or funds that receive the most attention. In support of this notion, research shows that money flows in more rapidly to mutual funds that have performed extremely well than flows out of from funds that have performed poorly.