“When it comes to investing money, people don’t always make rational decisions,” said John Nofsinger, associate professor in the Washington State University College of Business. 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.
|
John Nofsinger
|
Nofsinger, the WSU Nihoul Faculty Fellow in Finance, said 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.
“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.
Nofsinger said 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. “We don’t learn well from stranger’s mistakes.”
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 investors instead of against them.
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.
Nofsinger said Americans have no money left to “throw” at the current recession. “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.”
“In 1991, we had a personal savings rate of about eight 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 said. “For the first time in the history of the data (since 1950), we are showing a negative new mortgage debt” people are not buying new homes or taking home equity loans.”
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.”
For more information, contact Nofsinger at 509-335-7200, or john_nofsinger@wsu.edu;
Visit: http://www.cb.wsu.edu/directory/profile.cfm?emp=nofsinger_john or http://www.cb.wsu.edu/~jnofsinger/
