An Introduction to the World of Behavioral Finance
Updated: Feb 21, 2021
Because nothing epitomizes irrationality like a two year old... In our work together, we talk about behavior a lot. This is because we believe behavior is one of the greatest, if not the greatest, key to financial success. In fact, Behavioral Finance refers to a very up-and-coming field of financial research. The majority of financial and economic models developed over the last 100 years assumed that humans were both knowledgeable and rational, but (as completely obvious as this may sound), we are not. This is where Behavioral Finance comes in, it takes a look at those models and accounts for the fact that humans are often neither knowledgeable nor rational. By identifying these common behavioral mistakes, we can know what to watch out for in our own behavior and try to avoid common pitfalls.
To start, we’d like to introduce some common mistakes that fall into two categories: 1) Errors in Information Processing and 2) Behavioral Biases.
Errors in Information Processing are errors that occur because we don’t understand or correctly process the information that we use to make our decisions. Some common examples of this are:
Forecasting errors - investors tend to put too much emphasis on recent experiences while downplaying the significance of older events.
Overconfidence - investors often overestimate their abilities and the precision of their forecasts, explaining why many highly paid professionals are poor investors.
Conservatism- this is essentially the opposite of forecasting errors where investors are slow to update their beliefs and under-react to new information.
Sample Size Neglect and Representativeness- when investors are quick to assume patterns or trends based on small sample sets of data.
It’s clear to see how some, or all, of these information processing errors could cause investors to misallocate resources and even assume more risk than they understand. However, as we stated above, even when information is processed correctly, we still don’t always act rationally.
Behavioral Biases show that even when we understand the information correctly, we often still make inconsistent or incorrect decisions. Some common behavioral biases are:
Framing- how an investment is presented to an investor will often greatly dictate how they feel about the investment. For instance hearing “1/10 are winner!” vs. “you have a 90% chance of losing.”
Mental Accounting- investors segment funds based on where they came from or what they have mentally allocated them for. We see this with military clients who receive a stipend for housing and spend up to that amount when in reality it all enters their bank account just like the dollars in their paycheck.
Regret Avoidance- investors often don’t want to admit they’ve made a poor decision because of the unpleasant feelings that come from making a mistake, causing them to continue with their mistake and allow the losses to compound.
Prospect Theory- happiness is not as much dependent on a level of wealth as it is changes in current wealth, causing us to be riskier even when having reached levels of financial comfort and seek riskier investments in general.
Now that you’re familiar with a few common behavioral pitfalls, examine your own behavior on your next financial decision to see if you’re caught in one of these snares. Then, once you take an assessment of your behaviors you can adjust accordingly.