Kimberly Clouse, Private Client Advocate and Chair of Covestor’s Advisory Board, was recently interviewed by MainStreet about two behavioral biases that routinely hurt investors: anchoring and prospect theory.
She tells MainStreet:
Some investors rely on anchoring when making their investment decisions by basing it on “events or values with which they are familiar, even though they may have no bearing on the actual value,” said Kimberly Clouse, private client advocate at Covestor, a registered investment advisor.
People who follow this strategy are using irrelevant information as a reference point and often increase their risk instead of their reward. One common example is when an investor buys a stock at $100 per share, but learns that the financial situation at the company deteriorates for a significant reason. The stock price then falls to $80, but the investor still hangs onto the stock hoping that it will regain its value and rise back to $100 so he can break even at the price at which it was purchased, she said.
“They anchor the value of their investment to the value it once had – $100 in this case and instead of selling it to realize the loss, they take on greater risk by holding it in the hope it will go back up to its purchase price.”
Other investors follow prospect theory which asserts that losses have more emotional impact than an equivalent amount of gains, Clouse said.
Prospect theory “meets real world investing when you think about how much an investment’s value might fluctuate,” she said.
In a traditional way of thinking, the amount of utility gained from someone giving you $50 should be equal to a situation in which they were given $100 and then $50 was taken from them. The end result is a net gain of $50.
“Despite the fact that you still end up with a $50 gain in either case, most people view a single gain of $50 more favorably than gaining $100 and then losing $50,” Clouse said. “Even though you may end up with the same amount of money in the long run, a less volatile investment may ‘feel better.'”
Since people place different values on gains and losses, many of them will base decisions on perceived gains rather than perceived losses.
“If a person were given two equal choices with one expressed in terms of possible gains and the other in possible losses, people would choose the former – even when they achieve the same economic end result,” she said. “Individuals should examine their own biases and attempt to improve their investment decisions. Much of this so-called irrational behavior is adaptive.”
Read the full story at MainStreet.com.
