Understanding Behavioral Finance… How You Could Be Hurting Your Portfolio… Steps To Get Ahead
When it comes to investing, most people believe that rational decision-making leads to the best results.
Sounds good in theory. In practice, however, the reality is far from this ideal scenario.
The truth is, human emotions, biases, and decision-making processes play a significant role in our investing approach.
This is where the field of behavioral finance comes into play.
Both my colleague Jimmy Butts and myself have touched on behavioral finance concepts over the years. But today, I’d like to briefly summarize behavioral finance and discuss some key concepts can help you become a better investor. We’ll even cover some common biases you may or may not be aware of that could significantly impact your investment performance. (More on that in a second.)
But first, let’s talk about what exactly behavioral finance is…
What Is Behavioral Finance?
Behavioral finance studies how human psychology influences financial decisions and market outcomes. By combining insights from psychology and economics, behavioral finance aims to explain why people make certain financial decisions and how these decisions impact financial markets.
Several significant studies shed light on how our emotions, biases, and decision-making processes (or heuristics) can impact investment performance.
One was conducted by Daniel Kahneman and Amos Tversky, often called the fathers of behavioral economics. They found that people tend to make decisions based on mental shortcuts, or heuristics, rather than rationally analyzing all available information.
This makes sense when you think about it. For most of human history, we have had to make decisions that could involve life or death — and we’ve often had to do it quickly and without all the information. So it follows that we would come up with mental shortcuts to help us make (hopefully) optimal decisions.
However, we can run into trouble when we apply this in the modern world, especially regarding our finances, where things like rational analysis and long-term planning are critical. But if we can understand how our brain works (and why), we can make better investment decisions.
For example, emotions like fear and greed greatly affect how we invest. Studies have shown that the pain felt by, say, a 50% loss far outweighs the happiness or satisfaction we get from a 50% gain. Knowing this, we can work on managing those emotions and avoid making impulsive and irrational decisions. Even better, by understanding how the market behaves (i.e. other investors), we can take advantage and profit.
16 Ways Of Thinking That Can Hurt Your Portfolio
Behavioral economics is a broad (and growing) field that can’t be summarized entirely here. But if you can grasp just a few key ideas, you will be well ahead of most investors. So to help, I’ve put together a list of common human biases that can hinder investment performance…
1. Confirmation bias is the tendency to seek information that confirms one’s beliefs and ignore information that contradicts them.
2. Overconfidence bias is the belief that one’s investment decisions are always correct and that the future will play out as expected.
3. Anchoring is the tendency to rely too heavily on the first piece of information encountered when making decisions.
4. Herding is the tendency to follow the crowd and make decisions based on what others are doing rather than conducting independent research.
5. Availability/attention bias is the tendency to base investment decisions on easily available information or at the forefront of our attention.
6. Home bias is the preference for investing in one’s home country or region without considering the global investment landscape.
7. Favorite longshot bias is the tendency for investors to overvalue “longshots” like speculative growth stocks and relatively undervalue less risky investments (or “sure things”).
8. Myopic loss aversion is the tendency to avoid short-term losses, even at the cost of long-term gains.
9. Mental accounting is the tendency to treat different sources of money differently and make irrational investment decisions based on these mental categories.
10. The disposition effect is the tendency to sell winning investments too soon and hold onto losing investments for too long.
11. Hindsight bias is the belief that one could have accurately predicted the outcome of an event after it has already happened.
12. Get-even-itis is the urge to compensate for past losses by taking on excessive risk.
13. Representativeness bias is the tendency to categorize investments based on superficial similarities and ignore important differences.
14. Gambler’s fallacy is the belief that past events can influence future outcomes, leading to irrational investment decisions (ex: the dice rolls three 7s in a row, or that a stock is “due” for a rally).
15. Framing bias is the tendency to make different investment decisions based on how information is presented or framed.
16. Regret avoidance is the tendency to avoid making decisions that may lead to regret, even if those decisions are in one’s best interest.
Concepts To Help You Get Ahead…
You can get ahead in the market if you understand just a handful of these ideas. My advice would be to save this list or print it off for your reference later. In addition, there are several things you can do to help avoid these mistakes (investment heuristics, if you will).
Here are just a couple for starters…
- Diversification: spread your investments across various asset classes, sectors, and regions. This not only helps to reduce volatility and overall risk.
- Dollar-cost averaging: invest a fixed amount of money at regular intervals, regardless of market conditions. You can do this by setting up automatic deductions from your paycheck that go straight to your brokerage account and into a stock or fund of your choice. This also applies to dividends. If you don’t need the money now, have your brokerage automatically reinvest dividends (one less decision you have to make).
- Rebalance: every once in a while, adjust the mix of investments in your portfolio. Make sure they align with your goals and risk tolerance. For example, say tech outperforms in a year. You may find it overweighted compared to your preferences or risk tolerance. You can make these adjustments as often as you like, but it’s best to only do it a couple of times a year at most.
There is more to say, but the above strategies are all simple and straightforward. It doesn’t take a market guru to implement them. And once you do, they require little active brainpower to maintain.
There’s more to say about behavioral finance, but this is just to get you started. If you want to learn more, check out “Why Smart People Make Big Money Mistakes And How To Correct Them”. This book, by Gary Belsky and Thomas Gilovich, is written in a simple, engaging style. It examines many of the problems mentioned through short anecdotes and examples. They also offer some practical solutions and strategies to help overcome these mistakes. It’s a quick read, and I highly recommend it.
In the meantime, my colleague Jimmy Butts and his staff have just released a report of “shocking” predictions for 2023 (and beyond)…
This report is easily one of the most hotly-anticipated pieces of research we release each year. And if history is any guide, it could be one of the most profitable things you read all year…
From the U.S. dollar to driverless trucks to breakthrough cancer treatments and more… If you’re looking for ideas that could turn a modest investment into a small fortune, this is where you’ll find it.