When it comes to your investments and portfolio, are you overconfident? Are you just a bit too greedy? Do you panic at signs of a stock market drop, or become elated during latest surge? Do you choose stocks based on vague feelings? Does a 10% loss bring you more disappointment than an 11% gain brings happiness? If you're like most investors, the answer to at least some, if not all, of these questions is yes. (FYI, that includes us! We are just a susceptible to these mistakes, but knowledge is key.)
One of the keys to being a successful investor and reaching your financial goals, both over the long and short term, is being able to understand and control your irrational behavior (which most of us don't even believe exists in the first place). We all like to think of ourselves as cold, rational and calculating when it comes to our investment portfolio. However, the facts speak much differently. In fact, as we move through a number of irrational behaviors in this and the following articles, we can tell you that we have seen some or all of these behaviors in almost all of our clients. A major part of our job is recognizing these wealth-destroying behaviors, explaining to our clients how and why they are wealth destroyers, then assisting our clients in modifying these behaviors. Of course, and perhaps most critically, we must always be on alert when it comes to our own irrationality. It is just as easy for us to fall into these traps as it is for our clients and other investors, so we must remain ever vigilant.
What is Behavioral Finance?
Much of financial theory is based upon the idea that individuals act rationally and consider ALL available information in their decision-making processes. (Please!!) As this relates to the stock market, individuals in our industry commonly refer to this as the ?Efficient Market Hypothesis.? Surprisingly (though perhaps not, given our other fallibilities), researchers have uncovered an extremely large amount of evidence that this is frequently not the case; that we do not act rationally or consider all available information as this relates to investing and other life decisions. Dozens upon dozens of examples of irrational behavior and repeated errors in judgment have been studied and documented in various academic studies. In fact, in Peter Bernstein's famous book ?Against the Gods?, Mr. Bernstein states that the evidence uncovered ?reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty." Behavioral finance is a field of study that has evolved through attempts to better understand how emotions and illogical and cognitive (cognitive means it is based on empirical factual knowledge) errors influence investors. Both cognitive and emotional biases result in irrational decisions. Cognitive biases stem from faulty reasoning. Cognitive biases often result from the use of ?heuristics.? Heuristics are rules of thumb or strategies used to make a decision when people are overwhelmed by information. This often results in a quick, but typically not optimal, solution. Thus, better information and advice can often correct these cognitive biases. On the other hand, emotional biases originate from impulsive feelings or intuition (as opposed to conscious reasoning) and are thusly much more difficult to correct.
Types of Irrational Behavior and Biases
Some of the various types of cognitive biases include (we will explain and give interesting quizzes/examples of these terms in following articles):
- Anchoring and adjustment
- Selective memory
- Mental accounting
Emotional biases include but are not limited to:
- Lack of self-control
- Loss aversion
- Herding or groupthink
- Fear and greed
Now that we?ve defined behavioral finance as well as the various types of biases and irrational behaviors that we exhibit as people and as investors, we get to the fun part. In following articles we?ll explain these terms in plain English and demonstrate how they affect almost all investors. It is the recognition and constant monitoring of these faults and biases that can help make you financially successful and allow you to pursue your true life goals.