Some people have a misconception that successful investors must be highly rational and logical. They must study market analysis and make strategic moves based entirely on what the numbers tell them. In reality, every person who walks into an investment advisor’s office brings their unique experiences and beliefs with them, affecting how most of them make investment decisions. That’s why even very smart people don’t always make rational decisions about their money. Most humans are guided by emotions, biases, and personal history rather than pure logic.
This study of this concept is described as “behavioral finance.” It’s an area of economic theory that creates a context for how people approach investing and saving. Behavioral finance principles explore why a person might make a specific investment or refuse to let go of a failing stock even when they know they should. Think of it as the psychology of investing.
Understanding the core principles of behavioral finance can be a tremendously helpful tool for financial advisors and their clients. Recognizing the motivation behind clients’ investment plans allows advisors to address any underlying fears or misunderstandings and provide more information. As a result, clients can feel comfortable making informed investment decisions that (hopefully) lead to better outcomes and are still aligned with their long-term financial goals.
UNDERSTANDING BEHAVIORAL FINANCE
Behavioral finance is an alternative to more traditional economic theories. Per the Department of Labor, those theories assume “that people carefully consider all alternatives before making a decision, choose the optimal action, follow through on their intentions, and consistently respond to incentives.” In other words, traditional economics models expect that people who generally make choices about money will behave pragmatically. They’ll look at all the numbers and consider long-term outcomes before identifying the course of action most aligned with their goals.
The philosophy of behavioral finance explains why this is often not the case. People won’t always make predictable and rational decisions around investing and saving because human behavior isn’t always predictable or rational. Emotions and biases cloud judgment. People may misunderstand the risks and ramifications of their choices. They may act impulsively, driven by assumptions that aren’t based in fact.
Social dynamics are part of behavioral finance, too. For example, your decisions may be swayed by how your parents handled money, the people who are close to you today, and what you see other investors doing. Behavioral finance reminds us that all these factors shape how a person approaches investing.
BEHAVIORAL FINANCE CONCEPTS THAT AFFECT INVESTMENT DECISION-MAKING
While behavioral finance is a broad area of study, these are some fundamental principles that investment advisers see clients navigate repeatedly.
- Herd behavior is the instinct to copy what others are doing instead of making investment decisions based on your criteria, market analysis, and guidance from your advisors.
- Loss aversion is a tendency to prioritize avoiding losses over making gains, even when all things are equal. Imagine investing $10, with a 50/50 chance that you would either lose or double it. If the risk of losing the $10 feels like it outweighs the gain of winning $10, that’s an example of loss aversion.
- Overconfidence bias is the tendency to overestimate the likelihood that an investment decision will pay off, either because you overestimate your ability to analyze the market or because you expect that you’ll repeat a past success.
- Belief perseverance bias is the inability or unwillingness to let go of existing beliefs, even when new information disproves them is presented.
- Anchoring bias is the tendency to latch onto one piece of information early in the decision-making process and cling to that data point even if it loses relevance later.
PRACTICAL APPLICATIONS FOR INVESTMENT CLIENTS
Behavioral finance concepts shape the real-world investment decisions that clients make every day. Here are a few broad examples of how emotion, bias, and cognitive errors can appear in people.
- You buy an investment property for $300,000. A few years later, you decide to sell, but the property is now valued at $250,000. Because of anchoring bias, you fixate on the idea that it’s a $300K property and won’t accept less, even if it’s unrealistic to expect a $300K buyer.
- You’ve been on a hot streak for months, and every tweak you’ve made to your portfolio has grown its value. Bolstered by your recent stock market success, overconfidence leads you to make a new investment that’s much more volatile than you’re generally comfortable with.
- You hear some wealthy friends talking about a buzzy new IPO they’ve all invested in. They’re always up on the newest investment trends, so you assume they must know something you don’t know and decide to follow their lead without researching the company.
As you can imagine from these examples, being led by human behavior rather than rational analysis isn’t necessarily bad. Sometimes, following the herd or making an impulsive, risky choice pays off. And sometimes, it backfires, and you lose big. In those cases, you’re left wishing you had looped in your investment advisor earlier.
STRATEGIES TO MITIGATE BEHAVIORAL FINANCE BIASES
The goal of understanding behavioral finance isn’t to eradicate the “human factor” when making financial decisions. Your emotions, instincts, and experiences will always shape how you invest. Ignoring them to follow a purely rational investment strategy might not feel comfortable or be in line with your overall financial goals.
That said, your financial advisors can be a valuable resource for mitigating any biases or misconceptions affecting your planning. In this context, a trusted advisor can function like a financial therapist—asking probing questions, clarifying your goals, and helping you reframe your thinking when necessary.
Perhaps most importantly, advisors can provide context and data about specific moves their clients are considering. They bring a rational, pragmatic perspective to help clients make objective decisions. A good advisor will work with each client to create specific strategies aligned with their long-term financial goals in ways the client feels good about.
Ideally, clients should get comfortable calling their advisors for guidance before making major investment decisions. If you’re afraid your advisor will talk you out of doing something impulsive or irrational, call them anyway. Ultimately, you get to make your own decisions—don’t you want to have all the available information when you make them?
DO YOU KNOW WHAT ROLE BEHAVIORAL FINANCE PLAYS IN YOUR INVESTMENT DECISIONS?
Sachetta’s advisors meet every client where they are without judgment. We understand how behavioral finance principles shape our clients’ thinking, and we’re here to provide an objective, long-term perspective on their investment decisions. Don’t worry that you’re not considering an exciting new investment possibility—let your advisors help you assess whether it’s a good fit for your goals.
Do you have questions about how understanding behavioral finance principles could improve your investment outcomes? Contact me today.
Eric Sachetta, ChFC®, CFP®, is a Certified Financial Planner™ practitioner and focuses on financial planning and client relationship management. Eric believes that estate planning provides an opportunity to “look at all things that you value, see how they fit together, and make choices to balance everything and to maximize the things you want to do.”