Investors like to think of themselves as rational decision-makers. They analyze data, crunch numbers, and carefully consider their options before making a financial move. However, even the most intelligent and successful individuals can make seemingly irrational financial decisions. We’re all human, after all. This is where behavioral finance comes in.
What is Behavioral Finance?
Behavioral finance is a field of study that looks at the psychological factors that can influence financial decision-making. It helps explain why people might make decisions that go against their own best interests or that seem to defy logic.
Behavioral finance also looks at the role of emotions in financial decision-making. Fear, greed, and hope can all influence our financial decisions, leading us to make choices that may not be in our best interests.
Examples of Cognitive or Behavioral Biases
One of the key concepts in behavioral finance is the idea of cognitive or behavioral biases. These are mental shortcuts that our brains use to make decisions more efficiently in our busy lives. While cognitive biases can be helpful in some situations, they can also lead us astray when it comes to financial decision-making.
Sunk Cost Fallacy
For example, the sunk cost fallacy is the tendency to continue investing in something that is not performing well, simply because you have already invested a significant amount of time or money into it. If a sunk cost is involved, it makes it more difficult to let it go, even if you would be better off with out it. This can lead an investor to hold onto a losing stock for too long, or to invest more money in a failing business, rather than cutting their losses and moving on.
A more rational investment strategy is to acknowledge that you can’t control what has already happened to your investments. All you can do is position yourself well for future expected returns according to the evidence available.
Another common cognitive bias is herd mentality, or the tendency to follow the crowd. In investing, you’ll see herd mentality when an investor tries to time the market based on outside forces or trends.
This can lead someone to invest in a particular stock or asset simply because it is popular, rather than because it is a sound financial decision. Additionally, if a piece of the market is in a cold plunge, herd mentality can intensify fear and lead someone to sell a particular stock or asset because of a temporary trend instead of staying the course toward their long-term goals.
Another mental shortcut, familiarity bias allows you to more quickly trust (or more slowly reject) an object that is familiar to you. An investor may assume that familiar holdings are safer or better than foreign investments simply because the investor is more familiar with them, even if evidence proves otherwise.
Instead, take a step back and remember that a broad, globally diversified investment approach will best enable you to capture expected market returns while also mitigating risks.
How to Use Behavioral Finance to Your Advantage
Even once you know they’re there, you’ll probably still experience these cognitive biases. But understanding the psychological factors that can influence your financial decision-making can ultimately help you make smarter financial choices. You can recognize these biases when you experience them and defend against them the next time they’re threatening to derail your investment decisions.
By recognizing your own biases and emotions, and learning to manage them, you can make more rational financial decisions and avoid making costly mistakes.
Here are a few ways you can defend against these cognitive biases:
- Continue to increase your understanding of cognitive biases. The relationship between your mind and your money is fascinating to learn about.
- Anchor your investing in a solid plan with predetermined asset allocations that reflect your personal goals and risk tolerances. When a carefully constructed plan is in place, you’ll stand a much better chance of overcoming the biases that may rock your resolve during times of financial uncertainty or market volatility.
- Don’t go it alone. Trust the advice of your financial planner or objective wealth advisor who is well-versed in behavioral finance and dedicated to serving your financial interests. Sometimes it’s hard to recognize your own biases, but an objective, fiduciary third-party is a strong defense against these cognitive biases affecting your investment outcomes.
Here at Delap Wealth Advisory, we provide coordinated wealth advisory and financial mentorship. We deliver proactive planning strategies, goal-based financial solutions, and evidence-based investment management. Our team understands the unique intricacies, challenges, and opportunities clients face as it pertains to their complete wealth picture. Let’s start a conversation today to see how we can help you.
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