Investors Behaving Badly?

Physician's Money DigestNovember 2005
Volume 12
Issue 15

Economics and finance professorshave taught fordecades that markets areefficient and investors arerational, while presumingthat humans behave logically in all situations.Similarly, security prices at anypoint in time are assumed to reflectinvestors' collective rational assessmentof all known information. In this perfectyet theoretical world, there is noroom for pricing anomalies, arbitrageopportunities, or speculative bubbles.

New Financial Theory

Taking a very different approach incomparison to traditional financialphilosophies, behavioral finance incorporatesrecent psychology and neuroscienceadvances into the study of fundmanagement. Theories of behavioralfinance scientists and academics, includingMeir Statman, Richard Thaler,Hersh Shefrin, Amos Tversky, andRobert Shiller, are at odds with keyparadigms of traditional financial theory.This emerging branch attempts tounderstand how emotions and cognitioninfluence investors' decision-makingabilities, based on the premise thatfinancial choices are dictated more byemotions than by rational planningand risk assessment.

Faulty Fight or Flight

The problem:

For millions of years, our survival ashumans depended upon finely tuned"fight or flight" responses. Despite the fact that the world haschanged more dramatically in the past7 or 8 decades than the cumulativechange witnessed in all previous millennia,the brain has not had time toadapt, and thus humans react to situationsthat are rarely life threatening asif they were. Behavioral finance hasfound that this hardwiring can alsocause us to make investment decisionsthat are less than prudent.

Our first step for injecting rationalityinto the investing process is to acknowledgeour predisposition to behave badly(ie, react instinctively or impulsively).The following outlines some of thesebehavioral finance theories and theimplications for physician-investors:

1) Markets are inherently random.Our brains are disconcerted byunpredictability and at times do notknow whether to stay and fight or flee.To bring order, we as investors seekpatterns where none exist and gravitatetoward advice based on recentlyobserved trends or news stories. Insteadof trying to predict how inherentlyrandom markets will perform, staythe course and focus on what you cancontrol, such as spending less than youearn, making regular contributions toan IRA, or researching the fundamentalsof a specific company. Dollar-costaveraging, which is allocating a fixedamount to a particular investment on aregular schedule, can also removesome of the stress associated with futileattempts to accurately time marketentries or exits.

2) Rational decisions are impossiblewithout emotional engagement.Traditional financial theoryteaches that investment decisionsshould not be driven by emotional factors.However, neuroscience teachesthat decisions made in a Mr. Spocklikeemotionless vacuum do not accordenough weight to the risks involved. Inother words, it is impossible to make agood choice without embracing inputfrom one's head, heart, and gut.

3) Memories attached to intenseemotions are especially powerful.The daily deluge of financial coveragecan be unsettling, particularly if itevokes the fear and trauma of regretfulpast decisions. Remember that a journalist'sjob is not to help you feel positiveabout your investment choices, butto sell newspapers or airtime. To keepyour impulsive decisions based onintense emotions in check, write downyour core goals and the steps you aretaking to achieve them, and rereadthem often.

4) Being right feels good. Beingreally right, especially if the payoff wasa long shot, feels great. Some scientistshave shown that the flood of euphoricchemicals from certain events is similarto cocaine-induced highs (eg, daytraders and their addiction to computerscreens during the late 1990s). Toavoid the temptation of addictive andaggressive trading behavior, make along-term plan and stick with it.Reevaluate the plan only periodically(eg, on a neutral annual date or whenyour personal situation changes) anddo not become swept up by watchingfinancial news programs obsessively orchecking your investment balancesmultiple times a day.

5) Attribution bias affects selfesteem.When investment decisionswork out well, we chalk up the successto our own brilliance. However, whenplans go awry, we tend to blame others.Keep a balanced mindset regardingyour total investment picture anddiversify your holdings so that thedemise of one security doesn't have amajor impact on your entire portfolio,or your self-esteem. Also, resist theurge to give hot tips or recommendationsto friends and family members—they too will be tempted to keep thecredit or assign the blame.

6) We are overly optimistic andconfident. Investors regularly overestimatetheir acumen, especially if theyhave experienced recent luck, whichincreases beliefs that random marketplacescan be controlled. A combinationof overconfidence and overoptimismcauses investors to seek outinformation supporting their predisposedideas, causing them to onlychange their outlook gradually orgrudgingly. To counteract such tendencies,find data and opinions that runcounter to your ideas and weigh all evidenceequally.

By remembering the theories behindbehavioral finance, physician-investorscan learn to act rationally when investing,no matter how markets performor what the media may advise.Maintaining a well-diversified portfolio,balancing out investments that donot perform as expected, and keepingfight or flight tendencies in check canhelp you avoid behaving badly.

is a partner and principal of Lowry

Hill, a comprehensive, private wealth management

firm providing multifamily office

services for 20 years to more than 300 families

across the United States, with offices in

Minneapolis, Minn; Naples, Fla; and Scottsdale, Ariz.

Prospective clients are those wishing to invest at least

$10 million. She welcomes questions or comments at Lowry Hill does not warrant the accuracy

or completeness of the information. The above hypothetical

examples are for illustration purposes only. The information

included should not be regarded as an offer to sell or

as a solicitation of an offer to buy instruments mentioned in

it. Material contained herein should not be considered legal,

tax, investment, financial, or other professional advice.

Carol Clark

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