Roller coaster markets mean many are seeing their portfolios go up and down. TD Wealth has been digging into the psychology of this – with new research – called the TD Wealth Behavioural Finance Report. It sheds light on how investors react to losses. Kim Parlee talks to Dilip Soman, professor and director of the Behavioural Economics in Action Centre at the Rotman School of Management, about the study, the psychology of losses, and how a well-thought-out plan could save your bottom line.
Here to help shed some light and help us keep a level head, Dilip Soman. He is Professor and Director of the Behavioral Economics and Action Center at the Rotman School of Management. Dilip, it is great to have you here. Thanks so much for joining us.
I want to start with this number, 5%. We're going to show a bit more on this in a second. But why do you think 5%? Like, what's happening to our brains when we see a number like that?
Well, a couple of things happen when the numbers start declining. I think the first thing is the fact that we're loss averse. People don't like losses. And so when you see a numerical loss of 5%, it's coded as much more than that.
I think the second thing that happens is something that we call myopia in behavioral economics, that people tend to be fixated on the present without thinking through the broader implications. And so what you're seeing today might just be a blip when you look back at it a few years from now, but that's not the way it looks now.
We have a chart, I know, that you brought in, and I think this illustrates, perhaps, what the reality versus what we-- our interpretation of reality.
It does indeed. So if I look at this chart-- this is a fictional stock. Let's look at the green line. That's the price of the stock going up and down. The red line is the trend line. But the dotted line, the purple line, that's the psychological impact of the stock. And why that's different from the green line is the fact that losses hurt you twice as much as the gains make you happy.
And so essentially, now when you start looking at the dotted line, you see a lot more area under the mean, and that's why losses hurt you. Keep in mind that if you take a thin slice, that's when the impact of that loss is going to hurt you even more. If you looked at the big picture, probably not.
It'd be probably a good lesson in life in everything. But yes--
--particularly we feel it--
--in the markets. We have another thing that we saw in the TD Wealth Behavioral Finance Report. And I want to bring up a chart here. It's something called Nervousness to Decline.
But one thing that it highlighted was, depending how we hear about these losses-- and I think you allude to this-- it makes a difference in terms of how we react. So if I lost $2,500, that makes me feel better than if I lost 5%, as an example.
Correct. So it's all about framing. And I think it's all a function of how big the numbers are. $10 on a stock price that you've lost on a $20 stock, that's 50%. The same $10 on $1,000 stock is nothing. And so at the end of the day, it matters how you present the information, percent versus dollar signs. It matters if it's a chart versus numerical information. It matters if it's a line chart versus a bar chart. We've got lots of research showing that the human brain perceives information differently as a function of how it's presented.
And not only does the human brain perceive differently, but what gender that brain is in also seems to make a difference.
Oh, for sure. I think we have clear and consistent research that says two things. One, that women tend to be more vigilant. So when they see changes in trends, they pick up pretty quickly on that. The other thing that you'll see is that men tend to be more overconfident. And so as a result, they end up trading more.
We have a phenomenon called overreaction. When they see markets move, particularly when they see declines, they tend to trade a lot more. And we know that too much trading is not good for welfare.
Yeah, and I think it's really important. Because sometimes I think people misinterpret things. Oh, this is good and this is bad. It's neither. It's just, you just need to understand that the bias, I guess, that that's inherent in there. But that's a big number for women, if we can bring that chart up again. 71% versus-- when you see a decline--
--71% of women notice it right away versus the 29% of men.
They're vigilant. They're vigilant. The perceptual apparatus is strong.
The nervousness that comes from something like that-- so 71% say I'm nervous, for women, for example. I don't like this. Does that nervousness then cause us to make bad decisions?
It does. I think the psychology behind nervousness is something called regret. The idea that if I don't act, something bad might happen. And that memory of not acting is going to haunt you for a while. And so if I see the market declining and I don't sell, I feel like I'm going to punish myself forever going forward.
And that's why we tend to see the overreaction that we do. And so oftentimes it's not so much the nervousness per se, but people projecting themselves into the future and saying, what would I think of my actions when I saw the market decline and I didn't act?
I know that the research also brought up the idea of five traits that we all possess.
Again, not good, not bad. They're just traits. I think we can bring them up here. They are conscientiousness, openness, agreeableness, extroversion, and reactiveness.
And one thing that this research wanted to look at was, when it comes to satisfaction with how you're performing or your portfolio in general, a couple of these-- reactiveness was much higher-- and if we can bring up the chart and show this-- when you were less happy with how you're doing.
Right. And I think that's an interesting one. It's always tricky with this kind of research to figure out what's causing what.
So is it the case that I'm happy because I was reactive or not, or is it the other way around? But it's safe to say that they do go hand in hand. That's not a surprise.
And the other one here-- we can see on the screen-- the top one, if we can bring that up again, is conscientiousness. This one's really important, because if you are conscientious, and this is the idea that if you're, I guess, careful, you're forward thinking, you're probably going to have a better portfolio and you're probably going to feel better about things too.
This is huge. It's huge because I think conscientious people tend to plan, and we know that planning has two or three strong effects. It lets you anticipate different states of the world. It sets benchmarks. And you've thought a lot about what you're going to do should, in fact, the markets react the way you expect them to.
So people that plan for sure are going to be more satisfied, but they already-- they have a plan. They know what to do, and so they're not taken aback. It's not a reactive thing for them when they see the markets react.
And part of that might be sometimes, I know for myself, too, is you have to decide if you need help. In terms of--
--you may not want to do this yourself. You may have an advisor work for you, or whatever the case is. That may help you have a better plan in place to do it.
For sure. I think there's two or three things to keep in mind. One is that if you tend to view these negative slices of losses more often, you are much more likely to panic, be nervous, and react. And so maybe one naive prescription is don't look at the markets too often. Don't wake up every morning and start looking at your portfolios. But I think having that neutral perspective, having a second opinion, having an advisor, having someone to calm down the nerves, to take away the emotion, I think, will make a huge difference in the way you react.
Dilip, it is always a pleasure having you here. Thank you so much.
My pleasure. Thank you.
Dilip Soman is a Behavioral Economist with Rotman, the Director of Behavioral Economics and Action Center at the Rotman School of Management, and he joined me here in studio.