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Mind Games: What Behavioral Finance Can

Institutional investors long have had an unofficial adopting a consistent monthly investment plan. Although dollar cost
averaging doesn’t guarantee a profit and can’t protect against loss in
“rule” they call the “Odd Lot Theory.” Its premise is that a declining market, it can help you ease into the market, buying more
when small investors (those who purchase investment shares when prices are lower and fewer shares when prices are high.
shares in small lots rather than in multiples of 100) Over time, this can help lower the total average cost per share you pay
for your investments.
buy, that’s a signal for larger investors (those who
buy in multiples of 100 or more) to sell. Behavior #2: Herd behavior
Remember the dotcom bubble of the late 1990s, early 2000s? Like many
The reasoning behind this came from Garfield Dow, a young investment investing fads, the driving force behind this behavior is the tendency for
manager who, in the 1930s, noted that small investors as a group are individuals to mimic the actions (rational or irrational) of a larger group.
often wrong about when and what to buy. In other words, they tend to But as so many investors painfully learned, chasing the herd can be
buy high and sell low. risky. That’s because focusing on shortterm performance can hinder your
potential long-term success.
Does it hold true?
The lesson here? Before you jump on the bandwagon, do your homework
Of course, individual investors can be successful stock pickers. A recent and remember: Past performance does not guarantee future returns.
study conducted by Joshua Coval, a professor at Harvard Business School, Understanding what you’re buying and why is essential to making the right
concluded that one in five individual investors is able to consistently decisions for your unique circumstances and long-term investment goals.
produce aboveaverage equity returns. However, the study also found
that the vast majority of investors don’t fare as well.1 Behavior #3: Loss aversion
Behavioral finance teaches us that as investors, we tend to value gains
Why do so many individuals underperform the markets over time? and losses differently. In fact, some studies suggest that people feel a
That’s a question that economists and psychologists have been studying decline in the value of their investments twice as keenly as they do an
for more than three decades. This field of study is called behavioral increase of the same value. As a result, many investors are more willing
finance and its goal is to develop a framework to explain why people to sell their winners than they are to dump a losing investment.
make the decisions they do about their money. What they’ve discovered
is that when it comes to investing, rational choices don’t always apply. If you recognize loss aversion as part of your behavior, how do
What investors know, and what they actually do are often very different. you overcome it? Start by (1) building a broadly diversified mix of
investments to help soften the impact of market volatility on your
Mind over money overall portfolio; (2) rebalancing your investments on a regular basis to
ensure your portfolio is right for your particular goals, risk tolerance and
According to a 2011 study by leading research firm DALBAR, Inc.,
time frame; and (3) keeping your focus on your overall progress, not the
“Investment results are more dependent on investor behavior than
short-term ups and downs of your portfolio.
on fund performance.”2 The report also showed that most of this
underperformance is due to psychological factors that translate into
Behavior #4: Anchoring
poor timing when it comes to buying and selling investment shares.
Behaviorists have demonstrated that when it comes to making
So what are these behaviors and what can you do to avoid them? investment decisions, most people are strongly affected by “anchors,” or
Consider the following: points of reference, that may or may not be relevant to the decision at
hand. In other words, they tend to embrace information that supports
Behavior #1: Overconfidence their view rather than seeking information that contradicts it.
Optimism is a great thing to have in life, assuming it’s grounded in
The next time you think you have the market figured out, or you think
reality. Yet many investors overestimate their ability to beat the market,
you’ve spotted a portfolio manager who is on a winning streak, step
even when they have failed to do so in the past. Overconfidence can
back and look more closely. Are you seeing the markets through your
keep investors from meeting their goals because they may save or
own lens of hopes and projections or are you making decisions based
invest too little if they overestimate returns. It can also keep them
on fundamentals and facts? Remember, successful investors base
from learning from their mistakes.
their decisions on a variety of inputs in order to gain the truest picture
Rather than letting overconfidence derail your long-term plans, experts possible of an investment’s prospects.
suggest taking a more steady route to building financial security by
If you’re thinking about making a change in your portfolio, stop and list three reasons why that fund is a good idea, and three reasons why it isn’t.
This simple exercise will help you consider your decision from more than one angle. By focusing on the pluses and minuses of each investment
decision, you may be able to overcome the emotional swings that can keep you from getting the most from your investment decisions.

Your BMO Harris Financial Advisor will provide you with an unbiased recommendation designed to help keep
you on track toward your investment goals.

1
Maccaro, James, An Early Approach to Contrarian Investing, Working Money, The Investors’ Magazine, 2011, Working-Money.com.
2
DALBAR, Inc. 2011 Quantitative Analysis of Investor Behavior (QAIB) – Highlights, March 2011, www.dalbar.com.

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