Standard financial and investment theory holds that markets and investors are completely rational. The assumption is that investors exercise self-control and adhere to a defined investment discipline when making financial decisions. Therefore, those decisions are free of human emotion at all times. Yeah, right!

Behavior and Investing

The influence of human emotions on financial decision-making, known as behavioral finance or behavioral economics, has become an increasingly important area of study since the early 1990s. Behavioral finance, quite simply, is the study of how psychology and personal emotional biases can influence financial decision-making and move entire stock markets. Behavioral finance studies confirm that investors don’t always behave rationally and that human emotions play a huge role in decisions related to personal finance. Ultimately, the influence of our emotions on investment decisions often results in poor decision-making.

Why don’t investors behave rationally? Humans are emotional beings, and our emotions encompass the thoughts, feelings and experiences spanning our lifetimes. These affect how we feel and think.

Here are a few of the concepts, laid out by the Corporate Finance Institute, that influence our decisions:

• Confirmation bias: The inclination to rely on or act on information that affirms what we already believe while rejecting data or evidence that challenges those beliefs.
• Anchoring: Setting a preconceived spending level based on what we’re most familiar with, like paying more for a popular or favorite brand.
• Overconfidence and illusion of control: If we are right once, we’re more likely to think that we will continue to be right in the future.
• Herd mentality: We tend to imitate the financial behavior of the majority.
• Loss aversion: The fear of loss outweighs the excitement of or desire for gain.

Unfortunately, humans are hard-wired to make poor financial decisions, particularly when anxiety, fear, anger or excitement runs high.

A Recent Example

The events of 2020 revealed behavioral finance at work in investor responses to market volatility. The behaviors appeared to be dominated by confirmation bias, herd mentality and loss aversion.

At the beginning of the COVID-19 pandemic, investors were uncertain. Uncertainty led to confusion. Confusion quickly led to widespread panic. What followed was the S&P 500’s experiencing its fastest decline ever — from an all-time market high to bear market territory in just 33 days. How and why did that happen? Human behavior and emotional biases played a big role.

Then, the U.S. Federal Reserve announced no limit on what the central bank would do to rescue the economy. The S&P 500 recovered rapidly and recaptured its previous highs. Yet, the U.S. economy continues to operate at lower production levels and unemployment numbers remain high. How did all this happen despite depressed economic activity? Human behavior once again seems to be playing a big role.

Anchoring, combined with the emotional gap and herd mentality, might play a role in the public’s buying stocks we are most familiar with. Large-company U.S. growth stocks have attracted great investor interest, and billions of dollars are flowing into these stocks, led by the so-called FAANGs (Facebook, Amazon, Apple, Netflix and Google). The value of these stocks has risen dramatically since March 23, so what’s the problem?

If the past is any indication, the emotional comfort many are feeling might be only temporary.

Fear of Loss

The undercurrent in behavioral finance seems to be the fear of loss. We’ve found that typical investors fear loss at a much greater level than they feel the excitement of gain. Rationally, we know that investments involve risk and return. While you might assume that investors will weigh equally the potential for loss versus the potential for gain, studies show that investors fear loss more.

Equity mutual fund outflows accelerated as many investors exited the stock market by selling when the market was low, thereby securing real losses. Influenced by emotion, many failed to get reinvested when the market started its inevitable recovery. Others re-entered the market after most, if not all, of the market recovery was realized. Unfortunately, when investors operate from a base of fear and emotion instead of within the framework of a disciplined, long-term financial game plan, selling takes place around market lows and buying takes place around market highs. This is, of course, just the opposite of the most basic rule of investing: Buy low and sell high.

The financial industry understands behavioral finance all too well and has created products to capitalize on fear. Since the Great Recession of 2008-09, billions of dollars have poured into commission-based products called indexed annuities (life insurance products). These annuities promise that an investor will never again need to suffer from “fear of loss.” They offer guarantees that your account value will not decline when the stock market drops and that you will be allowed to participate in a portion of the gains when the market goes up.

These guarantees often come with high fees and a lot of fine print. For example, you might be limited in when you can access your money. It is common to be able to withdraw only 10% a year, and if you withdraw more, you will pay a surrender charge for anywhere from five to 15 years. The upside potential of your account likely will be limited. In return for giving you downside protection, the insurance company limits your upside. So, after high fees and all the fine print, what have you gained in the end?

These are products developed by life insurance company actuaries. Their job is to create a product that company agents can sell, and there’s no better way to sell a product than to use fear. These products are very effective at generating commissions for the sales agents and profits for the insurance company, but they might not be in your best interest.

What Can an Investor Do?

If humans are not wired to make rational, unemotional decisions at all times, what can we do? Act, don’t react, your way to success.

Investment diversification and asset allocation are critical, and your portfolios should be based on when you might need access to your money. We refer to this as a bucket strategy. While a specific investment recommendation cannot be made without detailed personalized information unique to each client situation, one might consider the following guidelines:

• Bucket 1: Money needed within two years (short term). It should be held in an FDIC-insured account that cannot lose value.
• Bucket 2: Money needed in three to six years (midterm). It should be invested moderately.
• Bucket 3: Money needed in seven-plus years (long term). It should be invested more aggressively because you have time to recover from market downturns.

These three buckets should be reallocated annually depending on market performance and unexpected cash needs. This method provides a disciplined approach across the entire economic cycle and helps you avoid having to sell stocks in a temporary down market.

Don’t do it alone. Meet with a certified financial planner to create a financial life plan customized to your circumstances and goals. The planning will force you to practice positive, financially lifesaving actions when the inevitable crisis comes. You need not fall victim to poor emotion-based decision-making.