During my discussion of fundamental and technical analysis, I have held an underlying assumption that investors act rationally. A rational investor makes decisions in an effort to maximize their wealth depending on their level of risk tolerance. On the contrary, evidence suggests investor irrationality exists in the market. For example, investors that missed out on stock market gains are experiencing feelings of regret that might encourage them to make irrational decisions. According to the Wall Street Journal, “Some who got out of stocks five years ago are fixating on how much richer they would have been if they had stayed put”. Making investments based on security analysis is a way to avoid making irrational decisions based on emotions such as regret. However, some investors struggle ignoring strong emotions. When they consider how much more profits they would have earned if they had not sold their stocks then they experience a powerful source of regret.
The psychological impact that this can have on an investor might lead them into making irrational decisions. According to the Wall Street Journal, “Conversely, if you have missed out, you may chase the rising market in a desperate attempt to get back to ‘break-even,’ or the level of wealth you would have had if you had stayed in all along”. Investing with a chip on your shoulder (i.e. in pursuit of missed profits) can cause investors to make irrational decisions that they would not otherwise make.
Psychologist Daniel Kahneman is often considered the father of behavioral finance, which is a school of thought that attempts to explain such irrational decision-making. A Random Walk Down Wall Street by Burton Malkiel discusses Kahneman who won the Nobel Memorial Prize in Economic Sciences for his work on behavioral finance. According to Malkiel,
“Behavioralists believe that market prices are highly imprecise. Moreover, people deviate in systematic ways from rationality, and the irrational trades of investors tend to be correlated. Behavioral finance then takes that statement further by asserting that it is possible to quantify or classify such irrational behavior. Basically, there are four factors that create irrational market behavior: over-confidence, biased judgments, herd mentality, and loss aversion” (237).
In this case, I believe the factors causing irrational market behavior is loss aversion followed by herding. Investors that sold their stocks five years ago likely did so because of the dire economic outlook at that time. Due to strong feelings of loss aversion, investors sold some or all of their stocks. According to Malkiel, “Kahneman and Tversky’s most important contribution is called prospect theory, which describes individual behavior in the face of risky situations where there are prospects of gains and losses… losses are considered far more undesirable than equivalent gains are desirable”. Five years ago was 2009 and the economic outlook was extremely uncertain at best (if not, very negative). The prospect of losses due to the poor economic outlook likely encouraged some investors to sell some or all of their stocks.
As the U.S. stock market tripled since 2009, some investors that sold their stocks are experiencing regret over forgone profits. Having initially sold stocks due to loss aversion, these investors begin to regret their decision because of the stock market’s continuous surge upwards. According to Malkiel, “Groups of individuals will sometimes reinforce one another into believing that some incorrect point of view is, in fact, the correct one”. Herding, which has pushed stock prices up over the past five years, has also convinced investors that sold their stocks that they were wrong in their decision. Now those investors that sold stocks are considering purchasing stocks to join the herd in hopes of making back missed profits.
An investor experiencing regret can take a few steps to control this feeling and avoid making an irrational decision. According to the Wall Street Journal, “First, engage in what Eric Johnson, a psychologist and director of the Center for Decision Sciences at Columbia Business School, calls ‘therapeutic reframing’, or looking at the same evidence from a different angle”. For example, consider how much lower your performance would have been if you sold out of stocks entirely. However, this would not help those that sold out of stocks completely. Second, an investor that is decided on buying stocks again can do so in a smart manner. According to the Wall Street Journal, “And if you feel you absolutely must buy more stocks to catch up, do so gradually by tiptoeing in over the next year or two in equal monthly installments”. I believe this is a good method for investing in general. As stock prices perform their random walk, spreading out your investment can spread out the price at which you purchase stocks and help avoid buying during peaks.