What is Behavioral Finance?
In 2002, psychologist Daniel Kahneman introduced the world to a new phrase, “behavioral finance,” and was awarded a Nobel prize in economics for integrating psychological research with economic science. We use this unique area of finance every day as we make decisions with heuristics (rules of thumb), frame and filter our financial decisions, and make nonrational economic decisions.
There are many biases included in behavioral finance. Let’s look at some common ones.
Overconfidence: Rating oneself above average when it comes to selecting investments.
One of the most common examples of this is the answer to the question, “Are you a better-than-average driver?” Most surveys show that 80-90% of drivers consider themselves above average – which clearly can’t be the case. This can lead to overfocusing on the potential upside of investments and de-emphasizing the potential downside of investments.
Herding: Following the crowd instead of making decisions independently.
Time and time again, the markets have demonstrated the fallacy of following what everyone else is doing. These include the early 2000s tech bubble, followed by the real estate and credit bubble of 2008. The implications here are the potential lost opportunities (as you’re following everyone else) and perhaps “doubling down” on items that are too risky.
Loss Aversion: Investors have shown a stronger desire to avoid losses as opposed to obtain gains by a ratio of 2-to-1.
Implications here are varied – you may hold onto losing positions too long, attempting to “get even.” In other instances, you may sell too quickly positions that have gains for fear of losing money.
See more: A Financially Healthy Future
Self-Control Bias: People do not always act in their best long-term interest because they lack self-control.
Some may overspend today rather than save for long-term goals such as retirement, which can result in sacrificing long-term goals or failing to benefit from long-term investing and dollar-cost averaging.
Hot Hand Fallacy: Perceiving trends where none exist and consequently taking action on this faulty observation.
A classic example is a study done on the performance of basketball players during games where their shooting is “hot” or “cold.” While fans believe that a player’s chances of making a basket are higher following a successful shot than following a miss, the study concluded that the outcomes of field goal and free throw attempts are mostly independent of the result of the previous attempt. In finance, this can lead us to invest in last year’s winners or favor “hot” money managers or asset classes.
Recency Bias: Similar to the Hot Hand Fallacy, investors overemphasize more recent events than those in the near or distant past.
An example is when investors only look at the last one-, two- or three-year track record when evaluating investment managers. This can lead investors to chase asset classes in favor of today or cause us to be overconfident and falsely extrapolate future returns.
Paradox of Choice: While conventional wisdom tells us that more choice leads to more happiness, having too many options does not increase performance or satisfaction.
We’ve all faced this dilemma from a shopping perspective: three or four choices, and we can make a decision; 24 choices and we’re overwhelmed. Having too many options can lead to dissatisfaction or even paralysis and the inability to make a decision. For many years, 401(k) plan providers continued to add funds to their offerings, but taking into account this bias, many have now pared down offerings to help participants make suitable choices.
See more: 4 Budget Plans to Improve Your Savings
Overcoming Our Weaknesses
If you find yourself exhibiting some of these behaviors, don’t be too hard on yourself – we’re all human, and genetics have wired much of these responses into our neural pathways. Many firms have quietly been providing queues or nudges to help us make better decisions, whether with auto-selection of 401(k) investment options in an appropriate target-date fund, auto-escalation of contribution percentages, or providing opt-out rather than opt-in choices. Here are a few other ways you can make better financial decisions:
- Get to know yourself. Become more aware of how your tendencies can influence your financial decisions.
- Avoid panic selling. Stay invested during times of market volatility and uncertainty.
- Stay focused. Don’t dwell on the past; focus on your long-term goals and time horizon.
- Consult with a trusted professional. Your financial professional can help take the emotion out of investing.
Joe Buhrmann is a Certified Financial Planner™ and manager of Financial Planning Support for COUNTRY Financial.