An important aspect of modern portfolio theory is based on the notion that individuals behave rationally during the investment process.
Those who have played fantasy sports or know someone who has understand that humans, including seasoned investors, aren't as rational as we often expect them to be.
Last year, DraftKings and FanDuel stopped allowing New Yorkers to enter its fantasy sports games because of questions about whether it was a game of skill or chance. Were people behaving rationally or irrationally when making their picks?
Emotions can cloud the decision-making process and distract investors from always acting in an appropriate, sensible manner. In turn, at times they may seek irrational ways to earn lottery-like payoffs.
Because of this, investors often are attracted to higher-beta lottery-like stocks and will typically overpay for them.
Ultimately, human irrationality leads to justifying these decisions as investors' emotions drive them to make choices that aren't optimal for their financial well-being.
Imagine that you are playing a game that offers two options for winning: You can either choose to win a guaranteed $10, or you can choose to take a risk and elect to have a 20% chance of winning $100. Even though the odds of winning the larger reward are only one in five, most people would rather take the gamble instead of the guaranteed win.
For some reason, a very slim chance of quickly doubling or tripling a payout is enticing to people.
This is one reason why investors still chase higher beta, risky stocks, even those that are overpriced. In doing so, it helps set the stage for lower-risk stocks to potentially outperform the market.
Data show that low-volatility stocks tend to outperform over full market cycles, so why do investors continue to chase higher-risk, higher-beta names? Behavioral research can help identify a few of the reasons, which are listed here.
1. Mental accounting
People tend to place events into mental compartments, and sometimes these compartments affect behavior more than the event itself. Behavioral researchers call this mental accounting.
For example, you want to go to a concert and tickets are $20 each. When you get to the venue you realize that you have lost a $20 bill.
Do you still buy a $20 ticket for the concert? According to behavioral finance, the majority of people would.
However, what if the situation was a bit different? Instead, you arrive at the venue and realize you left your ticket at home.
Would you pay $20 to purchase another ticket? In this situation, the majority of people wouldn't.
The funny thing is that in both scenarios, you are out $40. It is a different situation but the same amount of money, but you have simply placed two different events into two different mental compartments.
2. Over- and under-reacting
With gains and losses, it is easy to over- or under-react when the market goes up or down. Investors get optimistic when the market goes up but become extremely pessimistic during downturns.
Through these turns in the market, it is easy to become greedy or fearful. Investors tend to overreact to opportunities that sound extremely rewarding because they allow their emotions to take over, rather than judging ideas using logic.
Nicholas Barberis, an economist at Yale, argues that stocks with the lowest returns have the highest "positive skewness."
If a stock has positive skewness, investors become entranced by the chance of becoming very wealthy, even if that chance is very small. These investors think that their holding will become the next Microsoft or Netflix.
Due to poor judgment, they overweight the unlikely state of becoming very wealthy while staying invested and watching their returns fall.
By placing too much importance on recent events and ignoring historical data, investors can become blinded by the idea of their wealth increasing and subsequently over- or under-react to market events. For example, most of us know someone who sold at the market lows in 2009 after buying at the market highs just a couple of years earlier.
3. Prospect theory
It is safe to say that people prefer sure investment returns to uncertain ones. However, according to prospect theory, people express a different degree of emotion toward gains than toward losses.
People experience more stress and anguish from losses than they experience pleasure and satisfaction from equal gains.
For instance, a financial adviser with a client account of $5 million probably won't hear much from the client if the account rises 10% over the course of a year. However, a 10% loss will probably require a few extra phone calls and reassurances that the agreed-upon investment strategy is still on the right course.
According to prospect theory, a loss always appears larger than a gain of equal size.
4. Regret theory
Along with over- and under-reacting, regret theory deals with the emotional reaction that people experience after they realize that they have made an error in judgment. When faced with selling a stock, investors may become emotionally affected by the original price at which they purchased the stock.
After making a wrong choice like this, investors anticipate regret and take this anticipation into consideration when making decisions in the future.
A study published in Journal of Marketing Research found that after reviewing more than 700,000 stock purchases, investors were significantly more likely to repurchase stocks previously sold for a gain than stocks previously sold for a loss.
Investors were also more likely to repurchase stocks that had lost value, rather than gained it, since a prior sale. It is important to keep in mind that a stock doesn't remember where it traded last; only investors do.
At a glance, these behaviors make sense, but is it a wise investment strategy?
According to the results of the study, both patterns had marginally negative effects on returns because investors felt comfortable trading more frequently. This frequent trading lowered profits in the long-term and ultimately led to regret.
Fear of regret often plays a large role in dissuading or motivating someone to do something. However, this emotional behavior can have an impact on investors' finances, as well as within the markets.
These behavioral-finance theories and ideas reflect some of the attitudes within the investment system. Investors can be their own worst enemies if they take on too much risk through human irrationality.
In the long term, trying to outmaneuver or time the market will humble most investors. A well-diversified and managed portfolio of lower-risk, lower-volatility stocks may provide investors greater peace of mind, rather than the fear or regret felt by allowing their emotions to drive their financial decisions.