Behavioral Finance
Introduction
“Behavioral finance is the study of the effects of psychology on investors and financial markets. It focuses on explaining why investors often appear to lack self-control, act against their own best interest, and make decisions based on personal biases instead of facts.” Kaplan Financial explains this concept as one that requires discipline and delaying gratification, two things that are essential to becoming an effective investor. As the market ebbs and flows, investors must hold the attitude that, even though the market might not look great now, statistics prove that it will recover over time and return profits. When investing in stable areas of the market such as the DOW and the S&P, dips are routine, but growth is proven. However, though it may sound simple, it’s not as easy to stomach when you’re the one with money in the market! Let's get into how behavior plays an essential role in investing in stocks and bonds today.
Heuristics
An interesting concept that I believe is important to discuss is mental heuristics. These “heuristics” are mental shortcuts we can mistakenly use when trying to interpret the market; these can lead to poor behavior when investing in the market. A common example of this is the assumption that past returns indicate future performance. This is a heuristic that we must disprove fairly often, because in the human way of thinking of things, it’s easy to jump to. “An example of a common heuristic is to assume that past investment performance indicates future returns. Although that seems to make sense on the surface, it doesn’t take into account changes in the economy, or how fully valued a stock has become.” We can often have a cognitive bias towards stocks that have returned profits to us before, even when the stock may not be doing as well in the present. We can have mistaken loyalty towards certain companies simply because they’re familiar to us and haven’t seemed as risky in the past.
Behavioral Finance Biases
Self-attribution bias: It's simple – “the stock goes up, that’s my skill in investing. The stock goes down, that’s just bad luck.”
Confirmation bias: Wanting a stock to be good – paying attention to the parts that confirm the stock’s positivity and ignoring its possible downfalls.
Representative bias: Believing that one event has led to another, even if the events may not be as closely related as you think.
Framing bias: Jumping on a certain financial opportunity just because of the way it’s presented to you.
Anchoring bias: Allowing the first price presented to make up your whole opinion on a stock.
Loss aversion: Believing that losing some money is infinitely more impactful than gaining the same amount of money. For example, losing $100 means the end of the world, while making $100 is great, but not anything special.
Emotions in Finance
From my limited experience, I’ve come to see that emotions can be investor’s biggest indicators. All the concepts discussed above have something to do with emotions but relying on how you feel when you’re investing in the market could be the biggest mistake you can make – and we’ve all made it. Emotional reasoning is a massive pitfall when it comes to investing, and many times, even the facts or statistics that investors rely on can be based on emotions. All the biases mentioned above come into play here – if we feel badly about a stock, we’ll find all the possible statistics that enforce that belief, and we can always find them. It can be very tricky to have an objective opinion on the stocks you own, and that’s because they’re your stocks! When we personalize the investments we make, we can unrealistically protect them. We can also look at any whim of negativity in the market and want to sell everything off. I’ve heard the advisors here at our firm emphasize over and over – the market ebbs and flows, but we believe that it will always return to somewhat normal. Holding out in times of trial is one of the hardest things to do in investing, but we believe it yields the best results, especially when it comes to long term planning. Here at SWM, we emphasize to our clients that holding out through volatility is key. Adhering to the key guidelines of healthy investing can help alleviate stresses and worries, as we're able to trust the process. Having a diversified portfolio, riding waves of volatility, and regularly discussing your assets with an advisor are crucial practices when it comes to long-term investing.
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