Behavioral Finance

Napoleon Bonaparte once said, “Nothing is more difficult, and therefore more precious, than to be able to decide.” Financial decisions can be difficult in any environment. However, today’s wild market swings, the credit crisis, and the government’s unprecedented responses have stress running high, eliciting our brain’s most primitive protective responses. While those “fight or flight” instincts helped man survive in the jungle, they are not particularly helpful in making financial decisions in a recession.

When you’re under stress, your adrenal glands release adrenaline and cortisol hormones that affect your brain and cause a short-term focus, increased pessimism, impaired concentration, a reduced attention span, and decreased patience. When your perspective is altered by stress, you are more likely to make impulsive decisions that could negatively affect your finances.

The tenets of behavioral finance can help you to overcome market stress rather than be overwhelmed by it. Behavioral finance applies scientific research on our cognitive and emotional biases to better understand how we make financial decisions. In recent years, the field has moved into the limelight. In fact, in 2002, Daniel Kahneman, then a psychology professor at Princeton University, won the Nobel Prize in economics for his work exploring the common emotional quirks that govern financial decisions.

Among the behavioral patterns that impede rational financial decisions are the following:

Overconfidence. Most of us believe that we are superior to our neighbors. Kahneman reports that when he asks a group of people to assess their driving skills, 90 percent say they are above average. In the investment world, this overconfidence can translate into believing that you have unique insight into a stock or mutual fund.

Kahneman’s research also found that our desire to believe we are in control of our own destiny often leads us to identify patterns in purely random events. Unchecked, this false sense of control can lead you to believe you know which way the market is going.

Oversimplification. John Nofsinger is a professor of Finance at Washington State University and the author of several books, including The Psychology of Investing, Investment Blunders of the Rich and Famous, and Investment Madness: How Psychology Affects Your Investing and What to Do About It. He says our need for simplification results in our brains using shortcuts to analyze complex information. (You can read Professor Nofsinger’s blog, “Mind on My Money,” for more of his insights.) These “mental shortcuts” allow the brain to estimate the answer before we have fully digested all the available information. For example, the brain automatically assumes that things that share a few similar qualities are 100-percent alike and often embraces generally accepted “rules of thumb” without question.

The brain’s propensity toward oversimplification also leads us to prefer the familiar. You may, for example, have faith in a local company simply because you know people who work there, or you regularly see their trucks on local roads. Mental shortcuts not only introduce emotional prejudice into our analysis, but can make it difficult to correctly analyze new information.

Shortsightedness. Because last year’s market performance always looms largest in our memory, we wrongly assume that the recent past is the strongest indicator of future performance. Further, because we tend to focus on short-term gains and losses, investors not working with a financial advisor often overtrade their accounts—and that hurts returns.

Anchoring. Something called the “attachment bias” causes us to become emotionally attached to an investment. Just as our emotional attachment to our family and friends causes us to focus on their good traits and ignore their bad traits, when we become emotionally attached to a stock, we also fail to recognize bad news about the company. Unable to evaluate your investments objectively, you might hold on too long to portfolio losers because you expect they will bounce back.

Herding. Our need to belong is a crippling characteristic when it comes to investing.  Sometimes running with the crowd and losing seems better than winning alone. History proves that individual investors commit more money to the market as it rises and less as it falls, behavior that is opposite from that which would generate profits. But this behavior fits with our need to move with the crowd.

Mental Accounting. Another harmful practice is to view investment decisions and accounts in isolation.  Individual investors often take one approach with their 401(k) assets and another approach with their retirement or college savings accounts. It’s essential, however, to construct one, overarching financial picture in order to build an appropriate, well-diversified portfolio.

Loss Aversion. Because investment losses hurt us more than we appreciate gains, investors often gravitate to low-risk investments that may not generate the return required to meet their goals. It is important to recognize the point at which you must accept a particular level of risk in order to reach a goal and that it may be your aversion to accepting a loss that keeps you from parting with a declining investment.
With all these psychological biases influencing our ability to make rational decisions, it’s no wonder that in stressful markets we tend to feel less creative and often approach our financial decision-making with too much negativity.

Of course, as your trusted advisor, it’s my job to help you overcome these emotional biases, to think positively, and to make sound, rational investment decisions. Because research proves that knowing why you are investing curtails potentially harmful emotional responses, we review your financial goals on a regular basis. What’s more, because we evaluate your portfolio returns in the context of both your comprehensive financial plan and the market’s history, it’s easier for you to maintain a long-term investment perspective that is less prone to harmful short-term thinking. Finally, we have never advocated market timing and, particularly in this recession, we believe that lengthening your perspective and focusing on your long-term goals is the key to surviving this short-term downturn.

Of course, sometimes understanding how stress impacts your financial decisions isn’t enough to control your emotions. If you still find yourself anxious, limit activities that magnify your psychological biases. In other words, turn off the television. Stop surfing the Internet. Resist commiserating with friends and colleagues. Relax and rest assured that we continuously review and evaluate your portfolio versus your defined goals and strategies.

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