Many finance experts assume that investors act rationally to maximize profits while minimizing risks.
But as we write in our new Market Perspectives paper, investors routinely make a number of irrational missteps that can be explained by a growing body of behavioral finance research, which studies how people make money-related decisions. Here’s a look at three of these common investing bad behaviors.
Many people avoid risky assets like the stock market despite the high cost of staying out of such investments, particularly in the current, low-yield environment. Consider, for example, that adjusted for inflation, the return on cash left in a bank account was negative for 2014. In comparison, US equity markets as measured by the S&P 500 returned 14.7% during the same period.
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The graph above shows the total returns for the S&P 500 Index (SPY)(IVV) for 2014. The index returned 14.7% in the year and outperformed other developed markets (EFA) as well as emerging markets (EEM), which gave negative returns.
Holding US equities turned out to be a much better play than holding on to cash. Yet inflation dipped towards the end of the year due to falling oil (USO) prices, keeping cash in banks gave negative returns, thanks to a near-zero federal funds rate, which influences general interest rates.
Although equities involve a lot of volatility (VXX), they do provide the best returns in the long term.
The next part of this series explains why some investors have been avoiding the equity markets. It also shows the stock ownership percentage for investors.