October 29, 2012

3 Self-Defeating Investor Behaviors: Franklin Templeton

Advisors can help investors overcome negative psychology from the financial crisis, behavioral economist Dan Ariely says

The intricacies of investor psychology shed light on what people are doing to miss out on long-term opportunities—and on how advisors can help them overcome those behavioral hurdles, according to a recent report from Franklin Templeton Investments.

Behavioral phenomena can have a negative impact on investor psychology, says Franklin Templeton in a wide-ranging “thought leadership” comment, “2020 Vision: Time to Take Stock,” on its public website.

IDan Ariely, 'Predictably Irrational' authornvestors experienced loss during the 2008-2009 financial market crisis, and much of their negative perceptions of market growth stems from that time. As a result, many investors are afraid of experiencing the same sort of loss now.

With the help of Predictably Irrational author and behavioral economist Dan Ariely (left), Franklin Templeton pinpoints three behavioral reasons why investors may be missing out on opportunities for the long term:

1) Loss aversion. The fear of losing even more after suffering a loss paralyzes investors and prevents them from taking risks. This can cause investors to become overweight in perceived “safe” investments, according to Franklin Templeton. Unfortunately, this fear of any type of risk can lead to loss of potential gain.

Franklin Templeton Investments’ Beyond Bulls & Bears editorial team spoke to Dan Ariely, James B. Duke Professor of Psychology and Behavioral Economics at Duke University, who has studied people’s often irrational behaviors and actions, including the concept of loss aversion.

“He shared some insights with us about his experiments and findings about how we experience the pain of loss, and how it often overrides the reward felt from gain,” Beyond Bulls & Bears reports. “People hate losing much more than they enjoy winning. How happy are investors when they make 3% on their investments and how miserable are they when they lose 3%? There is a tremendous asymmetry.”

2) Availability bias. In a comment titled “When Do You Ignore Your Gut?,” Beyond Bulls & Bears describes how a person’s perceptions are shaped by environment and experience. For example, Franklin Templeton’s Global Investor Sentiment Survey found that investors currently believe the market was either down or flat in 2011 when in reality the S&P 500 saw gains.

“As humans, our thinking is strongly influenced by what is personally most relevant, recent or dramatic,” says the Beyond Bulls & Bears comment. “As investors, this can translate into perceptions colored by personal experiences that likely represent only a fraction of the complete economic picture. As an example: availability bias means that a person whose home has lost 20% of its market value and whose spouse endured a long period of unemployment is less likely to see or feel an economic recovery even while housing markets show signs of recovery and unemployment ticks down.”

Beyond Bulls & Bears goes on to quote Ariely, a Duke professor and author of Predictably Irrational: The Hidden Forces That Shape our Decisions, who asserts that a financial advisor could create different biases, depending on how he or she might frame a discussion about risk.

“Imagine if I was a financial advisor,” Ariely says, “and you came to talk to me about your risk attitude, and I started the discussion by asking you to describe how you felt in the last three years on the days when your portfolio lost 5% of its value. Then I asked you what your risk attitude was. Most people would say they don’t want to ever experience days like that again. On the other hand, what if instead I talked about people I knew who were retired and living in the Bahamas, fishing and golfing? Now your risk attitude would probably be different.”

3) Herding. Many consumers assume the consensus view is the correct one and follow the crowd whether they’re looking to buy a new phone or to invest money for retirement, Franklin Templeton’s Beyond Bulls & Bears editorial team notes in “Getting Trampled by the Herd.”

Chasing the market can lead investors to buy when prices are too high and sell when prices are too low. But on the flip side, value hunters can often find bargains if they move away from the crowd.

“The word ‘contrarian’ has a surly ring to it, but the idea of zigging when others are zagging is actually the foundation of the basic buy low/sell high investing strategy,” Beyond Bulls & Bears says. “The late Sir John Templeton had plenty to say about this type of behavior. One of his more famous lines: ‘Avoid the popular. When any method for selecting stocks becomes popular, then switch to unpopular methods.’”

Read The Upside of Irrationality, Investment Advisor’s cover story on Dan Ariely, at AdvisorOne.

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