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Written by: Jennifer Napper, CFP®, CDFA® | Peer Review: Annette Bau, CFP®
What is Behavioral Finance?
Behavioral finance is a study that blends traditional finance theory with psychology. The goal is to understand why people make the financial and investment decisions they do. It seeks to understand why investors behave the way they do and how this behavior affects the financial markets. Behavioral finance aims to understand how our emotions impact our financial decision-making.
The study of behavioral finance provides information that confirms that investors often behave irrationally, leading to lower long-term returns.
Why is It So Important?
Behavioral finance is important because it helps you understand why you make decisions that are not in your best interests. For example, traditional finance theory assumes that you are rational and make decisions based on a thorough analysis of available information.
However, research in behavioral finance has shown that this is not always the case. Investors are often influenced by biases, emotions, and other psychological factors, leading to suboptimal financial outcomes. By understanding these psychological drivers of investment behavior, investors can better predict market movements and make better financial decisions.
Other Types of Finance
It is helpful to understand the various types of finance and how they can be used to make informed decisions when investing. To achieve this goal, it is essential to have a good understanding of behavioral finance and other areas such as value investing, fundamental analysis, technical analysis, and derivatives trading.
Value investing involves buying stocks at a price below their intrinsic or “true” worth with the expectation that the stock will appreciate over time. Fundamental analysis looks at a company’s financial statements to make investment decisions. Technical analysis uses charts and other data to anticipate changes in stock prices. Derivatives trading involves buying or selling contracts such as futures, options, and swaps, which are based on the values of underlying assets. Each type of finance has advantages and disadvantages, so research them thoroughly before investing. Additionally, it is essential to have a comprehensive understanding of risk management to make informed investment decisions.
Why Investors are Irrational
Psychologists Daniel Kahneman and Amos Tversky have made significant contributions to the field. Their research focuses on psychological biases that impact financial decisions. They showed that people often make irrational decisions in financial markets because they are influenced by emotions, memories, and cognitive biases, not rational decisions.
A key finding was that people are more emotional about losses than gains of the same magnitude. This means that investors are more likely to avoid losses than to achieve profits. Emotional responses can be impacted by confirmation bias and occur even if this behavior is not in the investor’s best financial interests.
The Costs of Irrational Financial Behavior
The costs of irrational financial behavior can be significant for individual investors and the financial markets overall. For example, when you buy a stock that everyone else is buying, it is often over-valued, and then you lose money. Following the crowd can result in significant financial losses for individual investors.
Additionally, when investors exhibit anchoring bias, they may hold onto losing stocks for too long, resulting in more significant losses. The disposition effect can also cause investors to sell winning stocks too soon, missing out on potential gains. Finally, mental accounting can lead to lower performance because their investments do not align with their overall financial goals.
Types of Irrational Financial Behavior
Herd Mentality
This refers to the tendency for investors to follow the crowd rather than make decisions based on independent information. This can lead to an overvaluation of stocks and bubbles in the market.
Anchoring Bias
This occurs when investors become attached to an investment, even when the information suggests it may be time to sell. This can lead to suboptimal decision-making and financial losses.
The Disposition Effect
This refers to the tendency for investors to sell winning stocks too soon and hold losing stocks too long. This behavior can lead to suboptimal portfolio performance.
Mental Accounting
This refers to the way that investors categorize their financial assets and the impact that this has on investment choices. For example, some investors may view their retirement savings as “untouchable,” leading to suboptimal portfolio construction.
Tips to Avoid Emotional Investing
1. Understand your investment goals and risk tolerance
Before investing, it’s important to set realistic and measurable goals and remain focused on your long-term strategy. Understanding what you want to achieve through investing will help you make rational rather than emotional decisions.
Everyone has a different ability and willingness to accept risk. When investing, it’s essential to identify your level of risk tolerance and take steps to ensure that you don’t overexpose yourself to too much market volatility.
2. Hire a financial advisor, money coach, or qualified psychologist
While it seems logical to tell you to stop reacting to market downturns or to quit overspending, it is often another thing actually to do it. And that is where professionals can come to the rescue.
3. Do research
Investing shouldn’t be done without a plan or strategy in place. Research potential investments thoroughly and get to know the risk/reward potential of any investments you’re considering.
4. Develop a diversified portfolio
Diversification is an important part of any successful long-term investment strategy. Investing in different asset classes, industries, and markets can reduce your investments’ overall risk while still allowing you to participate in potential gains. Hiring a professional can help you create and maintain a diversified portfolio.
5. Invest for the long-term
It can be tempting to buy and sell stocks at every opportunity, but this often results in poor returns. Instead, focus on investing for the long term and try to purchase investments you’re comfortable holding onto over a longer period.
6. Re-balance your portfolio
Over time, some investments in your portfolio will become more or less valuable than others. By periodically re-balancing your portfolio, you can ensure that you’re not overexposed to any asset class or industry.
7. Don’t obsess over market fluctuations
The stock market is volatile and can experience sudden changes in value. It’s important to avoid watching price fluctuations too closely, as this can lead to making emotional decisions rather than sound financial ones.
8. Educate yourself
Understanding the inner workings of the stock market is essential for being a successful investor. Spending your time learning more about markets, financial products, and investing strategies can be beneficial in the long run.
9. Avoid rumors
It can be tempting to jump on board with stock market trends or rumors you hear from friends or family members. However, it’s important to do your own research before investing any money. Investing based on hearsay often leads to poor results.
10. Seek professional advice
If you’re not confident in your investing abilities, it may be beneficial to seek out the help of a financial advisor or investment manager. Professional advisors can provide helpful insight and guidance for making sound investment decisions.
Conclusion: Why Understanding Behavioral Finance is Critical for Investors
In conclusion, understanding behavioral finance is critical. And it helps investors who want to make better financial decisions and avoid the costs of irrational financial decisions. But implementing sound investment strategies not influenced by emotions, loss aversion, and biases can be more difficult than expected.
This is why it is important to have an experienced Certified Financial Planner (CFP®). They They can help you align your goals and objectives with your portfolio. Take the emotion out of investing in the stock market and start building wealth.
Related: Creating Wealth Inside and Out