Emotional investing, performance chasing and any other term we might use to describe investors’ penchant for harming themselves isn’t a new—or particularly insightful—concept on its face. But the study of exactly how they do it is another story.
Now that the tenets of behavioral economics are breaking through to the mainstream (finally), we thought it wise to take a look back at a compelling case made for variable products (yes, variable products) as one answer to this vexing problem. This article first appeared in our sister publication, Boomer Market Advisor, in 2005, but the message is just as important—if not more so—today.
Straight from the source
“One of the assumptions economists typically make is that individuals are fully rational,” explains Dr. Daniel Kahneman, a Nobel laureate and psychology professor at Princeton University. “If you want an easy introduction to behavioral economics, it’s economics without making the assumption that [investors] are fully rational or that they have perfect self-control.”
“The definition of behavioral economics in my mind is how people react, and the economic decisions they make, in any given financial framework,” adds Dr. John Nofsinger, associate professor of finance at Washington State University and author of “Investment Madness.” “Some would argue that all finance is behavioral finance, meaning that financial decisions are too often based on emotion.”
According to Kahneman, behavioral economics includes four interwoven parts:
1. Prospect Theory: Simply put, prospect theory is the notion that individuals sometimes behave irrationally. When confronted with a risky decision, they condense available choices to a short list of alternatives and then choose the one with the perceived highest value.
2. Loss Aversion: “I realize this business is driven by hope for gain versus fear of loss,” says Robert Brimmer, an Orleans, Mass.-based Certified Financial Planner. “People are much more motivated by the latter rather than the former.”
Brimmer’s conclusion is reinforced by Kahneman’s research, which found that individuals have a tendency to be more concerned with decreases, rather than increases in the value of their investments, as well as with protection of principal.
3. Mental Accounting: Individuals typically segment their finances into separate mental boxes, using the finances in each account for different purposes. On the surface, this seems harmless enough, but investors often take it too far. Short-term decisions about the contents of any one box can negatively affect the long-term returns of the whole portfolio.
4. Overconfidence: Just as people hate to admit when they are wrong, they hate to admit to a lack of knowledge. Investors have a tendency to display overconfidence by thinking they can go it alone when it comes to making investment decisions.