If being financially well were as easy as spending less money than you make, saving 10% of your paycheck, and buying low and selling high – our nation would look quite different financially. One of our goals here at Your Money Line is to increase your knowledge of finance related topics. Of course, our team can’t give you investment advice but we can help you learn about vital concepts such as risk tolerance, risk capacity, and diversification. But how can we help you bridge the gap between book knowledge and application? Enter, behavioral finance.
Though a relatively new topic discussed in this space, behavioral finance can help us understand why we make some of our money decisions despite the fact that they might not be in our best interest. Behavioral finance is the study of psychological influences on investors and financial markets. The premise of behavioral finance is that investors, as a whole, don’t make rational decisions and our money biases, scripts, and emotions are the cause. The key for you is to identify some of your biases in order to prevent making irrational decisions.
Analysis Paralysis
When making a big decision sometimes we have a hard time moving from a data gathering phase into a decision making phase. If you often find yourself stuck in this place you’re suffering from analysis paralysis.
Solution: Give yourself a research deadline. Don’t rush through the decision making process but don’t allow making a decision to be placed on the back burner. Consider sharing this deadline with a friend, partner, or even a member of our team.
Hindsight Bias
One of the most common biases. Hindsight biases exist when persons feel like they saw an event coming after the fact. Almost a decade and a half from the previous housing market crash there are many who think this event was easily predicted. Unless you are Michael Burry, you likely didn’t see this coming.
Solution: Recognize that patterns can exist in investing but also stay rooted in the number of times you hear predictions that never pan out. Remember, a broken clock is still right twice each day.
Herd Behavior
Common and dangerous. Herd behavior is the tendency of investors to make decisions based on the majority. Herd behavior can lead to buying high and selling low.
Example: Converting your portfolio to cash if the market enters a correction. You can be more susceptible to herd behavior if you’re not investing according to your risk tolerance.
Anchoring
When you become attached to a specific price and believe the investment will return to that price. This bias exists often with attachment bias.
Confirmation Bias
The tendency to seek out and believe information that supports our preconceived notions.
Diversification Error
Occurs when you, in an attempt to diversify your holdings, choose too many options. This is very common in employer-sponsored plans. If an employee is presented with a list of investment options they might choose them all. In reality, they are likely better served in choosing a small handful of options and/or a target date fund.
Familiarity Bias
When investors tend to purchase companies they know/trust. Just because a brand is national doesn’t mean it’s a good investment. Companies fail all the time. Remember Enron?
Mental Accounting
It doesn’t matter where the money came from. Birthday money from grandma doesn’t take more risk than your fixed monthly investment.
Overconfidence
Too much of a good thing? As you learn more about investing, your biases, and markets, you might tip the scale into overconfidence. Remember, even Warren Buffett makes bad investments.
Correlation vs Causation
Investors, in an attempt to understand markets often look to patterns that aren’t there. A full moon is not an indicator of whether you should make an investment decision. Correlation does not always equal causation. If we apply this logic you also believe an increase in ice cream sales causes crime rates to rise.
Being aware of your bias(es) isn’t enough to ensure you make better decisions in respect to your investment(s), but it’s a great start. Consider having conversations with your friends, family, and/or partner. When friends or family start talking about investing try to think about what biases they might be showing if you’re compelled to make an investment decision. Finally, try to mitigate your behavioral risk when possible by increasing your knowledge, updating your risk tolerance questionnaire, and investing based on logic and not aforementioned bias.
