Control Yourself

How psychological biases can make a mess of our financial decisions. Especially these days.

By VERONICA DAGHER

If you’ve watched your 401(k) lose 40% of its value, seen the U.S. banking industry crumble or simply read the headlines, it could be a challenge not to respond out of angst. After all, it’s only human to react emotionally to the news—especially when your money is on the line.

But when emotions become the overriding reason for making investment decisions, you could end up losing more money in the long run.

“One could try to explain all the events of the last several months with models and ratios, but it’s become more and more difficult to do so,” says Richard Thaler, professor of behavioral science and economics at the Booth School of Business at the University of Chicago.

The field of behavioral finance seeks to explain the set of psychological biases that affect people’s investment decisions. If you couldn’t bring yourself to sell a loser stock, or if you have picked investments because they felt “safe,” there’s a good chance you’re managing your money with your heart and not your head. Since our biases are aggravated when our brains feel overly excited or afraid—like when the Dow drops 1,000 points—you might find yourself making investment moves that you’ve never considered before, or feeling particularly panicky about your money.

Jungle Instincts

For hundreds of thousands of years, a human being’s survival depended on his or her ability to analyze a situation based on limited information and then make quick emotion-based decisions such as fighting, hiding or running away. “What was a great trait for surviving and thriving in the jungle doesn’t work so well in the stock market,” says Brad Klontz, a Kapaa, Hawaii-based financial psychologist.

So what are these emotion-based behaviors that hurt our investing performance?

One of the more common examples is a so-called “anchoring” bias. Everyone develops attachments that can be irrational sometimes, whether to a house, a car, even a person. People can also get overly attached to a particular investment, believing it will reach—or return to—a certain price. Or they may place too much importance on one piece of information when making an investment decision. These are examples of anchoring bias, which causes the investor to hold on to the asset for longer than they should.

Most investors know there are turning points in the fortunes of markets and companies, even if they don’t recognize the moment every time. But those with a “recency bias” assume events or patterns of the past will continue into the future. Recent memories of loss or prosperity are the guiding force for this type of investor’s investment decisions.

In 2005, Kirk Kinder, a Bel Air, Md., financial planner, met with potential clients who wanted him to create a plan for them that began by assuming an estimated 11% annual appreciation rate on their beachfront condo in St. Petersburg, Fla. The couple figured that was a conservative estimate as the property value had grown more than 20% over the past couple of years. Mr. Kinder told them he wanted to use a 3% growth rate at most, given his knowledge of real-estate appreciation. Mr. Kinder says the couple, who had little in the way of investments, insisted that he model the 11% growth rate, and didn’t hire him as an adviser when he wouldn’t.

He says the value of the property, which was estimated at about $510,000 four years ago, is probably down at least 20% from that point.

‘Loss Aversion’

Another type of bias can cause an investor to ignore realities and do nothing.

“I can’t sell now. Look how much I have lost!” is what Eric Toya, a Redondo Beach, Calif., financial adviser, heard recently from a client in her mid-30s. Mr. Toya’s client was reluctant to realize her losses on a large-cap stock she owned which he had strongly advised her to sell before it did more damage to her portfolio.

This “loss aversion” bias has become more common due to the market turmoil, behavioral-finance experts say. Because losses hurt so much, investors tell themselves it’s not a loss until they sell. “She was hoping inaction would eventually make the losses go away. It didn’t work,” says Mr. Toya. He says the client ended up seeing that stock investment continue to drop, despite his repeated suggestions to sell.

That same client also has what behavioral-finance experts refer to as the “endowment effect” in which an investor takes comfort in the familiar. She felt her holdings in some big U.S. companies were better than other stocks or investment sectors that she didn’t want to own. When investors have an endowment-effect bias, they assign a greater value to what they own than to what they don’t own, whether that value is warranted or not.

Investors with an “overconfidence” bias often trade too much and manage their portfolio on a stock-by-stock basis—while assuming they can beat the market, which the University of Chicago’s Mr. Thaler says probably won’t happen.

Deborah Hoskins, a Colorado Springs, Colo., financial adviser, has a 66-year-old, recently laid-off client who insists on keeping 85% of his portfolio in equities, despite her many recommendations to the contrary. She says the client may soon be facing a cash-flow problem but refuses to talk about adjusting his allocation as he is certain he has clearer insight into the market than Ms. Hoskins or many of his former advisers.

Mr. Thaler recommends a little test for the presence of an overconfidence bias. “Write down 10 traits [such as ‘investment skill’ or ‘ability to make good stock picks’], then ask yourself how you rate compared to your co-workers. If you rate yourself above average on all of them, plead guilty,” he says.

Observers agree it can be difficult for people to recognize the different types of biases in themselves, and even more difficult to overcome them.

“I don’t think these biases are easily remedied, even by a psychotherapist,” says Ronald Wilcox, a professor at the University of Virginia Darden School of Business. However, while many of these biases exist for a good evolutionary reason, he says, investors and financial advisers can work to lessen some of their effects.

Take Some Advice

Joel Fortney, an analyst at Des Moines-based Principal Global Investors, recommends individual investors take a cue from professional investors who use very specific criteria to choose investments—such as selecting companies with solid balance sheets that pay dividends. Mr. Fortney says setting guidelines and sticking to them helps alleviate some of the emotions that can cloud investors’ decision-making process.

“Be disciplined and focused on tested methods,” he says.

Nicholas Yrizarry, a Reston, Va., financial adviser, suggests investors put greater emphasis on other areas of their life—such as their families and good health, to put things in perspective and lessen anxiety. Stepping away from the situation before you make a quick investment decision also can help, he says. “It’s impossible to see yourself when you’re the movie,” says Mr. Yrizarry.

--Ms. Dagher is a staff reporter for Dow Jones Newswires in Jersey City, N.J. She can be reached at veronica.dagher@dowjones.com.