Behavioral Finance Basics

Andy Reynolds

As an advocate for our clients’ finances we spend a lot of time talking with clients about the decisions they make and how feelings can affect decision making.  I have told many clients that a good financial planner should be part investment-guru, part planning-guru, part-sounding board, and part-therapist.  All kidding aside, with most of our clients the relationship moves between all of these areas during different aspects in one’s life.  Our goal has been and continues to be to deliver sound, personalized advice that is unwavering no matter the outside influences.

 

To provide this type of advice, we work diligently to educate ourselves as best as we can about the markets, the economy, risks/opportunities in different investment types, etc.  We also focus much time on learning advanced planning strategies, while also having a core belief in all clients having a financial roadmap of where they want to go and how we can help them get there.

 

One thing we also strive to discuss with clients is the basics of behavioral finance.  Behavioral finance has roots in behavioral economics, which “combines insights from the fields of psychology and economics to elucidate decision-making, with an eye towards outcomes that might be deemed irrational in some frameworks.¹”  In other words, it is a study of why people consistently make irrational decisions.  This is an area that we as a firm have a great deal of interest in; we try to better understand our clients as people to help lead them towards better decision making.

 

Below we highlight a handful of common behavioral finance challenges that impact human decision making.  Most people can likely identify with a few of them.

 

Overconfidence – This one is rather straightforward.  We as Americans generally believe that we are better than what we really are and overestimate the accuracy of our predictions.  An example of this is from a 1980 study completed by the University of Stockholm² which asked American drivers if they are a better driver than the median driver.  Not surprisingly 88% acknowledged that they are a safer driver than the median driver2.  For an investor, this could result in excessive risk taking relative to their true comfort level.

 

Herding – Herding occurs when a given individual wants to follow along with how others are doing.  Humans generally want to fit in and do not want to be the one who is left out.  Therefore, herding can impact investors as they hear that everyone is into a certain area (Bitcoin!!) and they want to follow suit to be amongst others.  Additionally, we often get the question “how am I doing relative to my peers?”  While it should only matter how you are doing relative to your own personal goals, many people want to be in the same positions to their peers while making similar decisions.

 

Familiarity Bias – Humans are innately fearful of change and things that are new.  Therefore, we will flock to things that we have experienced before, as we can easily understand a set of outcomes that we have already experienced.  For investors, familiarity bias plays a VERY important role when considering investment volatility.  An older investor may be more comfortable with market volatility, as they have seen it before.  However, newer investors who have only experienced a 10-year bull market, may be more concerned when the market does take a correction.

 

Anchoring – Anchoring may be one of the more important concepts to understand, as well.  Anchoring generally means that individuals judge their outcome relative to an original reference point rather than a modified reference point when more information becomes available.  This can lead to inaccurate judgements rather than an analysis of well thought through criteria.  An example of this is an investor who is reviewing their portfolio simply relative to a starting point or certain threshold ($1M).  An investor who is not anchoring would critically evaluate the portfolio relative to how each aspect of the portfolio has done in relation to its own benchmark goal.

 

Behavioral finance can play just as important of a role in the result of a person’s financial outcome as the actual investments they invest in.  Understanding how these factors can influence you as an investor is very important.  Falling susceptible to these innate human emotions can lead to missed opportunities or poor/irrational decision making.  It is our goal to help eliminate these poor decisions by staying aware of the factors that influence our decision-making process.

 

  1. https://www.psychologytoday.com/us/basics/behavioral-economics
  2. https://pdfs.semanticscholar.org/ad37/e00352406dd776bc010769489b2412951c7d.pdf
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