As human beings, we have ingrained tendencies to let our short-term emotions guide our longer-term decisions, such as investing. For example, strong emotions can quickly cause us to misinterpret facts and make the wrong moves at the wrong time — repeatedly.
To see how this cycle of emotions plays out in real life, consider the image below. It shows a hypothetical example of what happens to many investors. When the market is on the rise and racking up big gains, investors quickly change from being optimistic to excited to downright elated. They eventually start to worry that they’re being left behind by not buying stocks — that their friends are all getting rich and that they better invest heavily in stocks in order to look smart and make money. So, after spending weeks or even months watching the stock market post strong returns, they buy in or ramp up their allocation to stocks.
Typically what happens is that shortly thereafter the market starts to show signs of weakness and begins to fall. At first, investors might be a bit concerned about these developments, but they find reassurance by telling themselves that “it’s only a temporary setback.” But it isn’t. Stock prices continue to decline, and investors become alarmed and frightened — with a growing certainty that “it’s different this time” and that stocks have become a sucker’s bet that will never pay off. As that fear really kicks in, they sell their stocks and buy bonds.
If you paid attention at all during the past several years, you know what typically happens next. Stocks begin to rally once again — often unexpectedly posting outsized gains in a very short window of time.
The bottom line for too many investors is that they buy at the top, driven by elation and greed. They then sell out at the bottom and lock in their losses, driven by fear. And they miss the start of the next upswing.
This cycle will no doubt look familiar to many of you. But the question remains: Why do we let our emotions replace our capacity for rational thought and drive our investment decisions in the first place?
The answer lies in a field of academic and economic study called behavioral finance, which studies the many biological and psychological factors that drive our decision-making processes. We like to think of ourselves as fairly rational, but behavioral finance shows otherwise.