A basic principle of investing is the efficient markets hypothesis, which states that investors are rational and will make logical investment decisions that aren’t based on emotion. If that is true, however, how can we explain market crashes, like the financial crisis in 2008, or the market crash in 1987, or even the crash in 1929?
The explanation, of course, is that investors don’t always make rational decisions. In fact, The Participant Effect incorporates the field of behavioral finance, which has emerged to explain why people make bad investment decisions. Behavioral finance looks at the intersection between psychology, sociology, and finance to understand the emotional processes that influence investment decisions. Why do people make investment mistakes and errors? Some reasons include:
Overconfidence. Human beings tend to overestimate their own skills and abilities, and men tend to be significantly more overconfident than women. One way overconfidence can affect investing is if an investor puts too much money into a single stock or company. This lack of diversification can increase the investor’s risk and cause greater impact on the investor’s portfolio if that investment loses value. However, there is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not protect against market risk.
Cognitive dissonance. This occurs when an investor faces two conflicting beliefs. He or she will attempt to reconcile this conflict by changing values or opinions, or by justifying or rationalizing a choice. For example, investors who made a bad investment might continue to stubbornly hold onto that investment, so they don’t have to admit to making a mistake.
Regret. Regret theory states that individuals will make decisions based on avoiding any feelings of regret later. So, for example, they might keep their entire portfolio in cash or cash equivalents, so they don’t ever have to experience any loss. Of course, that means the value of their savings may not outpace inflation.
Representativeness. This is the tendency to place too much weight on recent experience, rather than long-term data. For example, the stock market had strong returns from around 1990 to 2000, which caused some people to think that was the way it would “always” be.2 Anchoring. Sometimes called conservatism, anchoring tends to make people slow to recognize changes. They “anchor” on the way things have been up until now.
Encourage your participants The Participant Effect uses the principles of behavioral finance to help plan sponsors create effective retirement plans. We work with you to turn these psychological barriers into strengths, helping you increase your plan participation and helping your participants prepare for retirement. If you want to find out more about ways that behavioral finance can improve your plan’s success, browse the rest of our website, or call us at 1-888-968-9168.
This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.
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