Do you sit forever on the investment sidelines because you fear making a mistake? Can't bear to dump loser stocks even if it's in your best interest? Make investment decisions on the latest fad regardless of other information?
If so, your actions may be irrational, but they aren't surprising to the growing number of experts studying behavioral finance. This burgeoning field seeks to uncover how and why individuals make investment decisions, particularly poor ones.
It's not exactly a new science. For years, research has been done on the herd mentality that leads to stock market crashes, said Lawrence Raifman, a Baltimore psychologist who teaches a course on the subject at the Johns Hopkins University. But with the long-running bull market and the large number of small investors these days, more study is given now to the psychological reasons behind the individual's financial decisions, he said.
Behavioral finance can help investors to understand what errors they are prone to make and to develop an investment strategy to avoid those pitfalls, Raifman said.
It can also help financial advisers.
Robert Mewshaw, an investment counselor at Van Sant and Mewshaw Inc. in Lutherville, said he uses behavioral finance to understand clients.
For example, well-to-do clients who grew up during the Great Depression sometimes won't spend money or they will call Mewshaw asking if they can afford to buy a car, he said. Mewshaw shows them on paper that not only can they afford it, but they can buy one every year until they're 120 or so before their money runs dry. "That's what they really want, evidence that they are not going to run out of that money," he said.
Elizabeth Jetton, a financial planner with Financial Vision Advisors in Atlanta, also uses behavioral finance when interviewing new clients and gives them a brief personality test to learn their investing tendencies. "It makes it easier. If you don't do it, you eventually have to deal with the consequences of their behavior anyway," she said.
When Jetton comes across impulsive investors, for instance, she will set a 48-hour waiting period before they can act on investments. Or, if they can afford it, she'll have them set aside a certain amount of money to invest however they want while leaving the rest of their portfolio untouched.
Some investors, however, are so afraid of making a mistake that they will spend all their time analyzing an investment and never act upon it, Jetton said.
"People missed the bull market in the last few years because of procrastination," she said. Jetton gives procrastinators materials to analyze but sets a deadline for making decisions.
Roxane Dimon, one of Jetton's clients for five years, said she initially found it unusual that a financial adviser would explore her financial personality instead of delving directly into investments. Dimon said she tends to be conservative about money, whereas her husband views money as something to have a great time with first and save second.
That self-awareness helps them today, she said. "When we make decisions about spending money ... we can both see where our personalities play into it and come up with a compromise."
Experts say these are some other common behavioral traits that can lead to investment mistakes:
Overconfidence in one's investment abilities, a problem that may be more pronounced in today's bull market.
As the saying goes, "one of the biggest byproducts of a bull market is geniuses," said R. Douglas Van Eaton, a finance professor at the University of North Texas in Denton. But overconfidence can lead to too much trading, he said. The more you trade, the higher your costs, and you may also be hit by short-term capital gains taxes.
An aversion to loss can cause investors to sell winners in their portfolio to lock in profits and to hold onto losers in the hope they turn around.
"People who, for example, bought a stock and found it went down, tend to hold onto it because it is still a paper loss as long as they don't sell it," Meir Statman, a finance professor at Santa Clara University in California. "It's hope against hope."
Often, investors look for information that supports their beliefs and ignore contradicting data.
For example, investors who sold off stocks in the mid-1990s in the belief that the market was on the brink of a crash, now seek every piece of information that indicates a downturn is imminent, Statman said. And these investors will stay out of the market until it happens, he said.
Investors tend to use a form of mental accounting, or mentally putting money in different categories, experts said.
"We don't treat all of our money as equal," said Thomas Gilovich, a Cornell University psychology professor and co-author of "Why Smart People Make Big Money Mistakes."
People may readily blow a modest tax refund because they consider it a windfall, yet not invest an inheritance from a frugal grandmother because it's considered serious money, he said.
The source of money shouldn't dictate how it's spent or invested, he said.
Investors also tend to allow whatever is the current fad to have a bigger impact on their investment decisions than it should, Raifman said.
Investors may buy the latest hot tech stock whose name keeps cropping up, but ignore good companies not in the spotlight, he said.
"It's a mistake for an investor to overemphasize what is current just because it's current," he said.
Similarly, investors may give more weight to the latest piece of bad news about a company or stock without looking at how that information fits into the big picture, Raifman said.
Statman said he remains puzzled by one aspect of behavior: investors believing it's possible to forecast the unpredictable market. "People who would laugh at their horoscope do not laugh at the market forecast, yet they are equally accurate," he said.
Investors often would be better off with a portfolio of diverse, low-cost index funds, he said. "If they just left that alone, they will have so much more time for other things in life and, as a bonus , they will have more money," he said.
Do you have a personal finance issue of general interest that you would like to see addressed in this column? Contact Eileen Ambrose at 410-332-6984 or by e-mail at firstname.lastname@example.org.