Most people act like humans, not investors. But when it comes to investing, acting like a human may actually cost you money. The field of Behavioral Finance has become an important component of financial planning and investing. It proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. It also helps us understand how financial decisions around things like investments, payments, risk, and personal debt, are greatly influenced by human emotion, biases, and cognitive limitations of the mind in processing and responding to information. By understanding how and when people deviate from rational expectations, behavioral finance provides a blueprint to help us make better, more rational decisions when it comes to financial matters. Unfortunately, many financial advisors have no knowledge or expertise in this area.
A strong behavioral coach understands an investor's goals and fears and is able to help steer their financial behavior. It’s common for investors to become overly optimistic when markets are rising, or overly pessimistic when markets are declining. Left to their own devices, many investors buy high and sell low. An advisor can help an investor remain objective and disciplined through the cycle of market emotions. Avoiding behavioral mistakes is a significant contributor to the overall value of a financial advisor.
Behavioral Finance
An amusing and whimsical look at behavioral finance best practices for investors.
Following are some of the more common issues that, if addressed, could greatly improve a client's financial results.
Investors, Beware of MENTAL ACCOUNTING
A behavioral bias that leads us to put assets into mental categories based on where we acquired the assets and how we intend to use them.
This leads us to take undue risk with some assets while avoiding rational risk with others, based on the mental categories in which we've placed those assets.
What You Should Know
All assets should be handled in a manner consistent with one's entire financial picture. Unexpected money, like a bonus, shouldn't be spent frivolously and important funds, like retirement savings, in our opinion, shouldn't be invested with such low risk that they earn little to no return.
CONFIRMATION BIAS
Don't Let Headlines Confirm Your Investment Hypothesis
Confirmation bias is an investor behavior in which we subconsciously seek out evidence that confirms our hypothesis while tending to ignore evidence that disproves it.
Can lead investors to not consider all the facts and circumstances when making an investment decision.
Headlines can be found to confirm any investment hypothesis, but none of them can prove one.
Investors, Beware of RECENCY BIAS
A natural behavior that makes us biased towards recent events
Subconsciously, we overestimate the probability that recent events will happen again
Can cause deviations from long-term investment plans resulting in missed financial goals
Invesors, Beware of LOSS AVERSION
A natural behavior that makes us overly fearful of losses
Psychologically we hate to lose much more than we like to gain
Prevents logical choices and keeps us from potential gains
