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Behavioral Economics vs. Traditional Economics

May 04, 2022 | The Baum Jackson Investment Group


Buy low and sell high or buy high and sell low? One of the key questions differentiating behavioral and traditional economics.

Traditional economics suggests that if individuals are provided with all of the necessary information to make a decision, they will react in a rational manner. Behavioral economics suggests that due to human emotion, decisions are not always made with rationality in mind. It is the latter that often rears its head when it comes to investing.

Take for instance, the timing around buying and selling a stock.  From a rational point of view, it makes sense to purchase a stock after it has gone on sale (i.e. gone down in price) and it makes sense to sell a stock after it has gone up in price (i.e. sell at a higher price).  Hence the well-known mantra, buy low and sell high. In reality, it is not uncommon for individuals to feel emotionally upset after a large decline, wanting to sell to preserve what they have left, which is the opposite of what rational behavior would dictate. 

Dan Ariely, Duke University Professor of Psychology and Behavioral Economics, is a well-known figure in the field of behavioral economics. In a recent Barron’s article, he provided an example of how he stops his own irrational behavior, “I’ll tell you one thing I did. In 2008, when things were volatile in the financial markets, there was a weekend when I was headed to the mountains with my wife, and it looked like it was going to be a hairy Friday for stocks. So I logged in with the wrong password to my brokerage account. It locked me out, and that was it. I basically prevented myself from even looking.”1 This could be viewed as a rather extreme example, but it worked for him, preventing himself from acting emotionally, or irrationally. 

The reason we feel this topic is important for our clients is the effect that selling out of assets following a large decline can have on an established wealth plan. Assuming the original investment thesis is intact, and your financial situation hasn’t drastically changed, it is generally recommended that you maintain the strategic asset allocation originally established for you.

J.P. Morgan produced a study in their annual, “Guide to Retirement” booklet which speaks to this. The study found that 7 of the best 10 days of S&P 500 returns occurred within two weeks of the 10 worst stock market days. If, for example, you were invested in an S&P 500 index, and you missed the 10 best days within the time period studied (January 1, 2002-December 31, 2021), your return would drop from 9.52% per year to 5.33% per year2. This lower return may have significant impact on the health of your long-term financial plan.

It is nearly impossible to always make a rational decision, especially with something as emotional as your money. It is important however, to recognize when you are having irrational thoughts and to determine if a short-term decision is worth the potential long-term consequences. Perhaps locking yourself out of your own account isn’t the best approach, but it could be as simple as giving one of us a call to discuss how you are feeling. Together we can try to address those feelings. We are always here for you on good stock market days and bad.   Emotions are real; please don’t hesitate to call when you are concerned about the market. Volatility may be with us for a while, and although it is normal, we recognize just how uncomfortable it can feel.