John Nofsinger in College of Business Financial Markets Laboratory
“When it comes to investing money, people don’t always make rational decisions,” said John Nofsinger, associate professor in the Department of Finance and Nihoul Faculty Fellow in Finance. His viewpoint – which flies in the face of traditional investing theory – is shared by a growing number of researchers in the up-and-coming field of behavioral finance.
As Nofsinger explains in his book, “The Psychology of Investing,” finance theory originally was based on assumptions that people make rational decisions and unbiased predictions about the future in order to maximize their wealth. The idea that human emotion might play a role in that process was considered heretical.
But over the years, evidence mounted suggesting that mental bias could predictably influence investment choices – and the die-hard assumptions began losing their grip. In 2002, the field of behavioral finance was further sanctioned when psychologist Daniel Kahneman won the Nobel Prize in economics – spurring an explosion of new research in the area.
Today, Nofsinger is among those who study the effects of psychology on financial decisions, corporations and the financial markets. He also is researching various types of intervention, public policy and pension-plan design that may empower people to make better choices with their money.
Risk and return bias (buy low, sell high)
“The brain processes information through shortcuts and emotional filters referred to as psychological biases,” said Nofsinger. These biases can include things like pride, regret, overconfidence, the illusion of control and familiarity.
Another common bias is inaccurate risk perception.
“It’s a tenet of finance theory that risk and return go together,” said Nofsinger. “If you don’t want risk, you get a lower return. If you want a higher return, you need to take a higher risk. Interestingly, that’s not how people view it,” he said.
“To most people, a good investment is one that goes up with low risk – but anything with a high return is risky, so their beliefs are not consistent with theory.” For example, Nofsinger says that people wait until the stock market has risen for many years before having the trust to invest in it. “We have a psychological bias that fools us into thinking we’re not taking much risk when we really are – in fact, we’re buying high,” he said.
The same thing applies when people place all of their faith in buying one company’s stock for a retirement plan.
“They think they know the company well and so therefore it’s not risky to own that one stock – versus investing in the diversified S&P 500 Index, say,” said Nofsinger. “But it’s not true. When Enron and WorldCom went bankrupt, people lost their jobs and all of their retirement funds invested in their company’s stock.”
Yet, even with wide publicity about the Enron scandal, Nofsinger said people generally did not go to their company human resources department and ask to diversify their own holdings.
“The amount of their company’s stock owned in 401K plans didn’t change much after (Enron),” he said. “In fact, people often think their company is better and buy more stock. We don’t learn well from stranger’s mistakes.”
Simplifying the process
Hoping to help people overcome their innate biases, Nofsinger and others around the country are trying to develop policies and procedures that simplify the investment process – with the goal of making the biases work for a person instead of against him/her.
In most companies, “if new employees want to contribute to a retirement plan, they have to go into the HR department and sign up,” said Nofsinger. “Nationwide, not too many people do.”
This leads to a low participation rate – as people fail to opt into the plan. If, instead, enrollment was automatic and people were forced to actively decline, – it could lead to a much higher percentage contributing to retirement plans.
“A simple ‘opt-in versus opt-out’ makes a dramatic difference,” he said.
But once in a plan, Nofsinger said many people are reluctant to adjust those investments.
“They have a ‘status quo’ bias – they never reallocate or change their contribution once the account is set up,” he said. “So I’m trying to help people do what’s best for them even when they don’t know what’s best.”
Concerning the recent stock market crash and international recession, Nofsinger has a few tips. But he is also blunt when asked how soon it might blow over.
“I don’t see any way the American consumer can spend us out of this recession,” he said. “We are tapped out – over-extended – and we need to get healthy first.”
Referring to a graph showing rates of U.S. personal savings vs. new net mortgage debt since 1989, Nofsinger discussed the recessions of 1991 and 2001.
“In 1991, we had a personal savings rate of about 8 percent and new mortgage debt was fairly constant,” he said. “We got out of that recession by spending the money we used to save. That was the 90s when our homes and stocks all went up in value and the prevailing attitude was ‘consume,’” he said.
By 2001, the national savings rate had plummeted to zero and new mortgage debt was increasing rapidly along with the dot-com boom.
“People were taking home equity loans to put in stocks like Amazon.com,” said Nofsinger. “Interest rates were low and people were borrowing like crazy on credit cards and all kinds of things – so we were spending all our money and borrowing more to spend – and that’s what got us out of the 2001 recession.”
“But now what?” he asked. “For the first time in the history of the data (since 1950), we are showing a negative new mortgage debt” – i.e. people are not buying new homes or taking home equity loans.”
Mind on money and more
From thoughts on President Barack Obama’s stimulus package to the relationship between religious faith and investing, Nofsinger offers his take on the psychology of money matters in his blog on Psychology Today @
Nofsinger’s book, “The Psychology of Investing,” is available for sale and can be ordered from any bookstore or online at Amazon.com @
To learn more about Nofsinger’s research at Washington State University, see online @
Nationally, “we have racked up a huge amount of debt and we haven’t saved any money for years. All of the savings we had in real estate and stocks are way down too – so there is no money left to throw at the recession,” he said.
“I think we will have a slow economy for at least a couple years until the American consumer gets into a healthier financial situation. We won’t see the good times rolling for awhile.”
But Nofsinger does offer suggestions to investors who have the option to rearrange their funds.
“Shorter or medium term Treasuries and corporate bonds can give you a little return and a measure of safety in these times,” he said.
“And since the market will be up and down, wait until it goes up to sell if you feel you have too much invested – or if you don’t have enough, buy more when the market is down. “Buy low and sell high. It’s such an easy rule yet our biases cause us to do the opposite.”
“We kind of need to ride it out … and have a plan. If you realize you have too much risk and you’re not sleeping, then it’s time to use some nice rallies to decrease that risk,” he said. “It helps people sleep better to have a plan – it gives you some control in an environment that feels uncontrollable.”