Investment Strategist

Behavioral Finance and Irrational Investing

In 1996, then-Federal Reserve Chairman Alan

Greenspan coined the term “irrational exuberance"

in an address to describe investors’ attitudes

towards what he viewed as an overvalued stock

market. It is often used to describe the impact

that manic speculation and emotional decision-

making can have on the financial markets. The

soaring prices of “dot-com" stocks in the late

1990s and early 2000s and housing in 2007 and

2008 provided textbook examples of irrational

exuberance in action. But while the subsequent bursting of those bubbles resulted in significant

financial losses for many investors, will those same investors learn from their mistakes the next

time a boom and bust period occurs.

“Buy low, sell high" may sound like a simple formula for investing success, but history has

proven that, for many, adhering to this precept is often easier said than done. In recent years, the

field of behavioral finance has emerged to help explain why investors act the way they do, studying

such behaviors as herd mentality, overconfidence, excessive aversion to risk, and bias towards

recent market results. Any of these behaviors can be very damaging to a portfolio.

What Is Behavioral Finance.

The efficient market hypothesis states that it is impossible to beat the market because stock

market efficiency causes existing share prices to incorporate and reflect all known information.

It assumes that investors behave in a rational, predictable manner. However, this theory largely

ignores emotional biases (either on an individual or collective basis) that can lead investors to

make irrational decisions that can cause large fluctuations in the market. Behavioral finance seeks

to explain which psychological and emotional factors influence individuals’ investment decisions.

As you work toward your financial goals, developing an understanding of these factors, removing

emotion from your investment decisions, and not worrying about the short-term individual losses

and gains in your portfolio will make it easier for you to maintain perspective.

Taking the Emotion Out of Investing

The good news is that there are certain measures you can take to help reduce the emotional factor

of investing and help protect your portfolio from the extreme market volatility caused by irrational

exuberance. Adopting a long-term approach, diversifying your portfolio, and utilizing the power of

dollar-cost averaging are all simple ways to be less emotional in your investment decisions.

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Adopt a Long-Term Approach

Behavioral finance reveals that humans are prone to focus on the short term, even at the

expense of the long term. Due to the inherent risk involved in investing in the stock market,

it’s wise to take a long-term approach. Consider investing in equities for financial goals that

are at least five to ten years down the road, if not longer. Short-term goals (for needs occurring

in fewer than five years) may be better served by more conservative investments.

Investing for the long run can help you prevent two common behavioral mistakes that

investors make: bias towards recent market results and herd mentality. Recency bias occurs

when investors ignore long-term trends, considering only recent market developments when

making investment decisions. Because of the recency effect, for instance, stocks with high

values become popular with investors, who buy more shares, which then continues to drive

prices upward. It also means investors are likely to be easily scared off by short-term losses

even if there has been no fundamental cause for alarm.

Long-term investors are also less likely to adopt such a herd mentality of buying stocks that

the general public perceives to be “hot," or selling off stocks that have temporarily fallen out

of favor simply because of the perception that everyone else is doing it. However, those

who take this “lemming" approach may find themselves getting out of the market too early

or getting back in too late. Looking back over the history of the stock market, it has been

repeatedly demonstrated that the best time to invest is during periods of great pessimism

and the best time to sell is during periods of unbridled optimism, yet the vast majority of

us do the exact opposite.

Diversify Your Portfolio

Generally speaking, it is usually unwise to put all of your eggs in one basket, but

unfortunately, many investors may find themselves doing just that. Maintaining a diversified

portfolio, while not ensuring a profit or protecting against loss, may help you benefit from

market upswings while minimizing the impact of downswings. There are three keys to

diversification:

1. Incorporate a mix of investment vehicles, such as stocks, bonds, and cash.

2. Vary the risk in securities so that large losses in one area may be offset by gains in

other areas.

3. Vary your securities by industry or geography to minimize the impact of industry-

or location-specific risks.

Dollar-Cost Averaging

Many investors have tried to time the market, buying and selling stocks at what they consider

to be the perfect time. This can often be a recipe for disaster, as many who adopt this strategy

have portfolios that underperform as compared to the market as a whole. Dollar-cost averaging

can help reduce the risk of investing at the wrong time and potentially allow you to take

advantage of the ups and downs of the stock market.

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Dollar-cost averaging is simply investing equal or fixed amounts of money at regularly

scheduled intervals. With this investment strategy, you will buy more shares when the price

of your investment has declined and fewer shares when the price has risen. Over a period of

time, you may lower your average cost.

With dollar-cost averaging, you may reduce investment risk by not investing substantial

amounts at the wrong time. In addition, dollar-cost averaging forces you to invest on a regular

basis, making it well suited for long-term goals, such as retirement. By investing on a regular

basis, you can avoid making bad decisions based on emotions, such as the natural tendency

to stop investing in a weak market.

Investors need to consider that dollar-cost averaging does not assure a profit or protect

against a loss. Before embracing the dollar-cost averaging strategy, investors should consider

their ability to continue investing during periods of falling prices.

With dollar-cost averaging, the investment amount and frequency are up to you. The

success of dollar-cost averaging doesn’t depend on the amount or frequency you choose;

what matters is that you stick to your plan, regardless of what happens in the market. For this

reason, make sure that the investment amount you choose is consistent with your financial

means, so that you can continue to purchase shares even through periods of low share prices.

Stick to Your Plan With Automatic Investing

Many investors know that they should be investing for the future, but don’t always have a

lot of cash on hand. Or, perhaps they think investing requires a lot of money up front. There’s

a remedy to these problems. Your Financial Advisor can help you establish an automatic

investing plan – which will allow you to benefit from dollar-cost averaging – by arranging for

a set amount to be deducted automatically from your paycheck or directly from your bank

account. With Stifel’s Payroll Direct Deposit service, you can have as little as $25 from each

paycheck deposited directly into your Stifel account. With direct deposit, you can put money

aside before your monthly bills eat away at it. There’s no need to budget for investing, and

this convenient service is free of charge.

Get Professional Advice

Fortunately, when it comes to working towards

your financial goals, you’re not alone. Your

Stifel Financial Advisor is available to provide

objective advice to help you avoid making

rash decisions that could adversely affect your

portfolio. By taking the emotion out of investing

and adopting a methodical, long-term approach,

you’ll be more likely to meet the objectives

you’ve set for yourself.

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