Behavioral finance is the application of psychology to understanding financial behavior and its effect on portfolios and markets. Whereas traditional economic theory assumes people always make rational choices, behavioral finance takes into consideration the cognitive, emotional, and social factors that affect people’s decisions.
People view the world around them through different lenses due to their background, education, upbringing, and experiences. Over time, these lenses become hardwired into our brains. Biases are unavoidable, and if left untamed, they can lead to errors in financial decisions and other decision making.
Unless you have been living under a rock the last two years, you can probably understand how emotions and behavior can quickly change based on your surroundings and the news cycle of the day. As trusted advisors, it is important for us to be empathetic to your feelings. Yet it is equally important for us to be aware of common behavioral biases so that they don’t hinder your financial goals.
So what are behavioral biases? Behavioral finance commonly identifies two categories of behavioral biases, although many of these biases interact with each other during the decision making process. These two categories are “Cognitive Biases” and “Emotional Biases.”
Cognitive biases generally occur when you are presented with too much information – or information contrary to your understanding of the world. In these instances, it is natural to try to simplify things in order to make a decision or justify an opinion. Often the result is faulty thinking. Examples of cognitive biases include:
Confirmation Bias – A predisposition to seek or interpret information in a way that confirms our existing beliefs and to discount or disregard conflicting information.
Illusion of Control Bias – Overestimating our ability to control or influence the outcome of events.
Hindsight Bias – The inclination to see events as more predictable AFTER they have already occurred. Hindsight is 20/20, right?
Money, wealth, and investments are extremely emotional topics. However, when financial security is at stake, it’s crucial to make decisions without letting your emotions be the main driver. Examples of emotional biases include:
Loss Aversion Bias – The tendency to emphasize avoiding a loss over seeking a gain. The pain of losses hurt more than the satisfaction of gains.
Regret Aversion Bias – Not making a decision, or being indecisive, due to fear of making the wrong decision and experiencing a bad outcome.
Status Quo Bias – The tendency to do nothing or maintain a previous decision (good or bad) unless there is a compelling case to make a change.
The list goes on of psychological biases that we all possess. We can’t always take the emotions or past experiences out of investing. However, we can reduce the negative effects of biases by focusing on time-tested investment principles like diversification, maintaining proper allocations, rebalancing, tax efficiency, review, and communication.
Often when presented with facts outside your current frame of mind or knowledge base, a collaboration with your advisor can help produce more informed and better decisions. In a recent study by Vanguard,1 it was estimated that the impact of prudent behavioral coaching could add 150 basis points (1.5%) per year to annual returns. That adds up!
As trusted advisors, we continually educate ourselves on all aspects of financial planning. Behavioral finance is an emerging financial planning area that is crucial to successful investing in the world today. We incorporate these lessons as we work to create an investment strategy and plan that inspires confidence. Confidence in a plan helps tune out the noise of the day, look longer term, and minimize the effect of behavioral biases.
“Putting a value on your value: Quantifying Vanguard Advisor’s Alpha” February 2019
We’ve touched on behavioral finance in past newsletters. We previously recommended the book The Psychology of Money by Morgan Housel. The book explains many behavioral finance lessons in practical, relatable ways.