In their everyday lives, people are emotional – and often irrational – beings. Now, there’s a growing body of research that shows people are just as irrational when it comes to making investment decisions. They should be checking their emotions at the door, but instead are allowing them to sway their judgment.
“We assume people make rational decisions,” says C. Thomas Howard, chief executive officer and director of research at AthenaInvest, based out of Colorado. “Studies show this to be false. Almost zero rationality is involved and we must recognize that people make cognitive errors all the time.”
Professor Howard is a pioneer in the academic study of investor behaviour. As a professor of business at the University of Denver and author of Behavioral Portfolio Management, he has long studied human behaviour in relation to financial markets. He will tell you, for example, that the pain of loss is twice as strong as the pleasure of gain. He calls it “short-term loss aversion” and the pervasive and lasting recall of losses will often cause people to act in ways that are counter to their stated investment goals.
“Emotional brakes or triggers get in the way of investors truly maximizing their wealth,” he says, “and of staying on the path that was devised, specifically, to get them there.”
Professor Howard says that emotion-based decisions lead to mistakes, and investors’ cognitive errors create pricing distortions in the marketplace. These insights into investor behaviour — and the market opportunities presented by these emotion-driven behaviours — led him to establish AthenaInvest as an equity research firm, and to develop a formal framework for applying behavioural finance principles to portfolio management. “Behavioural Portfolio Management (BPM) assumes most investors make decisions based on emotional reactions,” he says.
Athena’s proprietary, patented database of fund and stock data allows it to analyze and quantify these pricing distortions and identify investment opportunities. Athena brings that expertise to the T.E. Wealth Prosperity family of pooled funds as a manager on the Prosperity U.S. Equity fund.
Professor Howard’s teachings have a number of implications. First, if market ups and downs are the result of investors’ emotional behaviour, BPM calls into dispute the concept of “informationally efficient” markets, as championed by Modern Portfolio Theory (MPT). This theory, which has dominated market thinking in recent years, holds that, although there is some level of emotionality in the markets, it is outdistanced by rational investors. Stock markets, therefore, are inherently rational and stock prices reflect actual values. Prices are set in response to a full set of information and markets are efficient.
Professor Howard doesn’t buy that. “Markets are not informationally efficient,” he maintains. Emotional crowds, he says, base decisions on anecdotal evidence and emotional reactions and that is what drives market prices. “There is almost no fundamental information reflected in stock prices.”
“Prices are always wrong. It’s a matter of degree.”
The other implication has to do with opportunity. If a stock’s value is obscured by the actions of emotional crowds, there are opportunities to buy stocks that are undervalued. But what is needed is a rational, disciplined approach to – and framework for identifying – those opportunities and acting on them.
It is perhaps this last point that has the greatest implications for individual investors. While Professor Howard believes emotions can lead investors astray, he also believes mastering emotions can lead to success. “Mastering one’s emotions and following a sound financial plan,” he says, “can dramatically improve the chances of avoiding the more common investor mistakes.”
He admits successful investing is emotionally difficult: humans are hardwired to seek out short-term emotional comfort. Yet, successful investing requires setting aside the short term and taking a long-term view, even when your investments are losing value. It can also mean investing when volatility is high and you are emotionally uncomfortable.
“Ignore volatility,’ he counsels. “Volatility doesn’t really matter in the long term.”
The successful investor will stand out from the crowd. What matters, Professor Howard says, is having a sound plan and the discipline to stick to it. In keeping with this philosophy, T.E. Wealth seeks to help you establish an investment plan that fits your goals and risk tolerance, while showing you the merits of sticking with that plan during short-term market dislocations.
Tessa Wilmott is a Toronto-based editor, writer and researcher specializing in the financial services sector.
This article was published in T.E. Wealth’s Strategies newsletter, Nov 2016 edition. Read the full edition here.