Behavioral Finance: It's Not Just the Numbers as published in InsideNova.com
As a seasoned advisor with a long list of financial credentials, I’d probably be pegged by most people as a “numbers guy.” It’s true, I am quite fond of charts and spreadsheets. But any advisor worth his (or her) salt quickly learns numbers alone aren’t enough to get the job done. We also must be well-versed in behavioral finance, i.e., the many threats investors face from the emotional, instinct-driven side of money management.
As humans, we are hard wired to be lousy investors. We cringe at the very risks that are expected to generate our greatest rewards. We incorporate irrelevant information into our investment decision making. We react to market movements instead of sticking with our original, thoughtful plan.
Why do we do this? Most of the behavioral biases that influence our investment decisions come from mental shortcuts we depend on to think more efficiently and act more effectively in our busy, everyday lives. Usually these short-cuts work well. But otherwise helpful instincts can turn deadly in investing. They gang up on us, confuse us and contribute to multiple levels of damage done, including:
- Counterproductive trading – Behavioral bias tricks us into buying when prices are high and selling when they’re low.
- Excessive risk-taking – We focus on investment returns without considering the risk taken to achieve them.
- Overreacting to near-term price swings – Tolerating price volatility is the trade-off for higher expected returns. Avoiding it can lead to returns that are too low to reach your goals.
Academia has studied these phenomena over the past several decades, publishing a treasure trove of robust research on behavioral finance. Practitioners have then harnessed these findings to identify and manage investor biases in pursuit of improved investment outcomes.
In future columns, I intend to cover some of the specific, most damaging behavioral biases I see damaging people’s financial future. In the meantime, I’ve published a white paper, “The ABCs of Behavioral Biases.” I invite you to read it if you’d like to take a closer look at some of the inner workings of our fascinating brains. Food for thought!