What is driving your financial decisions? Is it getting in the way of good results? To set the stage for a solid understanding of how you can help yourself to better financial decision making, you must first understand the history of work done in this area.
Neoclassical economists who emerged in 1900, believed that an investor’s primary concern was to maximize personal satisfaction. This theory coincides with rational behavior theory, which states that people act rationally when making economic decisions. Rational behavior theory can be traced back to the 1700’s and the economist Adam Smith. Fast forward to 1960, the efficient market hypothesis developed by Eugene Fama, states that asset prices reflect all available information. It too relies on the idea that investors behave rationally. Efficient market theory believes that when prices do not reflect real value, people will notice and will act with the result that the market corrects itself. If only that were true. People are not always rational, and markets are not always efficient. To test that conclusion, think of other areas of human interaction where you have personal experience. To maintain that investors, behave rationally in making choices ignores the vulnerability of human nature to emotional responses.
What is behavioral finance?
Behavior finance, a sub field of behavior economics which incorporates modern psychological research, arose in the 1980’s. It proposes that psychological influences and biases affect financial behaviors of investors. The purpose of behavior finance is to study why people do not always make the decisions they are expected to make and why markets do not reliably behave as they are expected to behave.
A bias is defined as a predisposition to a view that inhibits objective thinking. Biases can cause people to emphasize or discount information. Biases can also lead to a strong attachment to an idea or an inability to recognize an opportunity. When you then experience a crisis like we have in 2020, these biases are exacerbated, and it amplifies problematic thinking.
There are many emotional and cognitive biases that can impact our decision making. This article will outline some that can dramatically affect financial and investment decisions.
What gets in the way?
Loss aversion is when investors prefer to avoid losses over acquiring gains. An example of this is when one chooses to sell in a market downturn to avoid further losses even when the reasoning and research supports holding or buying more of that investment. This causes an investor to lock in losses and miss the upswing in the market.
Confirmation bias occurs when people overvalue or seek out information that only confirms their beliefs, while ignoring information that discounts that belief. The risk here is that an investor may not understand the likely decline of an investment
Recency bias is the tendency to overvalue recent events and extrapolate patterns where they do not exist. If you hear the words or utter the words “It’s different this time”, recency bias is in play.
Herd mentality bias refers to investors’ tendency to follow and copy what other investors are doing. They are largely influenced by emotion and instinct, rather than by their own independent analysis. A prime example was the sell off during the pandemic of this year.
There is good news. Once you understand what may be getting in the way of solid decision making, while you cannot remove emotions, you can help mitigate them. The more you understand your emotions and anticipate those behaviors, the better your financial decision making can be.
Stay focused on your goals.
To help mitigate emotional decision making, Fragasso Financial Advisors incorporates several tools into our process. We believe a systematic approach to investing is imperative. Utilizing goals-based investing helps us to understand from the very first conversation what you are trying to accomplish.
Understanding your individual investment profile is important in this process. This includes your stage of life, sources of wealth, short- and long-term goals and your risk tolerance. I want to stress the word “individual” here. Every investor’s goals and financial picture are unique. Your risk tolerance is a perfect example of this. Measuring your risk tolerance helps us determine how emotionally comfortable a person is with taking financial risk. It is psychological and is best measured with a psychometric tool. We utilize a 10-question survey that helps pinpoint your tolerance for risk. By knowing how comfortable a client is with investment ups and downs, advisors can make sure their clients do not panic and hurt themselves during scary times.
Once all this information is gathered, we create a financial plan based on an objective analysis of your goals, risk tolerance and time frame. Once the plan is created, our firm analyzes the plan as a group. We do this every Friday morning where our advisors and financial planning analysts dissect your plan to create a recommendation that we feel best suits your situation. It is important to point this step out because advisors also have their own emotional and cognitive biases…we all do. An individual advisor does not come up with recommendations, we do it as a team. That helps us flush out any individual biases one may have and combines decades of knowledge and experience in the industry.
This plan becomes the roadmap, the starting point to help you make good sound decisions in the short- and long-term. When there are changes or there is panic, we go back to that plan and determine how specific decisions or events can impact your long-term goals. This takes the emotionality out of it. You and you advisor revisit this plan annually and throughout the year. You will especially revisit it during volatile times like we are experiencing this year to not succumb to the biases that can negatively impact you. You and your advisor are a team. We are here to talk through those tough times. We are here for you for the long-term. We guide for life.