Why your investments don't
perform as they should

Behavioral Finance says it's because you don't think straight about money

By Charles Lasnier

Doctors do not, as a rule, have sterling reputations for their acumen as investors. Be comforted, you're not alone. In fact there's a whole field of study emerging that tries to uncover why so many people make poor decisions when it comes to accumulating money. It's called "behavioral finance".

RIGHT THINKING
Like many theories that fly in the face of conventional wisdom, behavioral finance got its start in academia. University of Chicago professor Richard Thaler, one of its pioneers, started to research the topic in the early 1970s. Nearly three decades later, Princeton University's Daniel Kahneman won the Nobel Prize for his work on the subject. Despite its ivory tower pedigree, however, behavioral finance is not universally accepted.

Most of its naysayers adhere to the traditional efficient market theory, which contends that there is perfect information in the stock market. Because everyone has the same information about a stock, the thinking goes, its price should reflect the knowledge and expectations of all investors. Carrying that reasoning to the extreme, no investors should be able to "beat the market" since there is no way for them to know something about a stock that isn't already reflected in its price.

Behavioral finance, on the other hand, attempts to uncover repeated patterns of inconsistency in the way people make financial decisions. It identifies three ways in which investors trip themselves up:

IS THIS YOU?
Mental Accounting: Instead of looking at the big picture, people tend to mentally compartmentalize their assets into different "buckets," which they manage independently, and treat differently. If you do that, it's easy to lose sight of the fact that each category of money — regardless of source — contributes to overall wealth. The tax refund is one example of mental accounting; buying on credit is another. Some believe, in the back of their minds, that a dollar charged on plastic is somehow less damaging to their bank accounts than paying cash. This may explain why so many use their credit cards recklessly. This same kind of thinking can blind investors to the fact that marginal decisions can affect the entire portfolio.

Loss Aversion: People hate to lose, especially when it comes to admitting they made an investment mistake. In fact, studies show that investors typically consider the loss of $1 two-and-a-half times as painful as the pleasure of gaining $1. This could well explain why many investors gravitate toward the low-yielding 'safe' returns of money market instruments even though they have a time horizon and financial goals that warrant a more aggressive strategy. Another example: When stock prices fall, many believe that, if they don't sell, the loss on paper isn't "real." In the process, these investors can watch a significant portion of their net worth disappear while waiting for their investments to climb back to previous levels.

Overconfidence: Many investors falsely believe that they are as good, or even better, at picking stocks as everyone else with access to the same information. Investors may fall into a similar pitfall when they attempt to time the market. The financial media often fosters this fallacy by promoting the views of so called "experts." In addition, most investors have short-term memories when it comes to their losses, which can lead to unrealistic expectations about their abilities. That may explain why few are willing to discuss their investment failures and are too often reluctant to seek professional financial advice.

Recognize yourself in one or more of the traits described above? Next time you're looking for financial advice, check to see if the purveyor of those words of wisdom understands the emotional side of investing as well as what's hot and what's not. Behavioral finance may not be an exact science, but it can help you better understand, and avoid succumbing to, human tendencies that have the potential to derail financial goals.

Charles Lasnier is an Associate Portfolio Manager with RBC Dominion Securities Inc. Member CIPF.

This article is for information purposes only. Please consult with a professional advisor before taking any action based on information in this article. Charles Lasnier can be reached at [email protected].

RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member CIPF. rRegistered trademark of Royal Bank of Canada. Used under licence. RBC Dominion Securities is a registered trademark of Royal Bank of Canada. Used under licence. cCopyright 2007. All rights reserved.