Over the course of a day, we make hundreds of decisions. Will I eat a salad or pizza for lunch? How much should I tip my server? Should I take the trash out now or later? Many of your daily decisions require little thought. Making decisions regarding your finances, however, requires careful thought and attention to detail. Occasionally, investors may lack self-control, act irrationally or make poor financial decisions based on personal biases over facts.
Traditionally, financial theory suggests that markets and investors are rational and demonstrate self-control. Recently, however, some studies suggest that this may not be the case all the time. Behavioral finance, a combination of financial psychology and behavioral economics, suggests psychological influences and biases affect investor behavior. Psychologists and economists attempt to understand human biases as it relates to investing and managing money.
Below, we discuss a few major concepts of behavioral finance and some points that may pique your interest when considering future investments.
1) Self-attribution is a popular concept in general psychology. In finance, self-attribution is a unique combination of investor overconfidence and incorrect choices. Investors may attribute their successes to knowledge and foresight and impute their failures to outside influences or misreads. A well-suited investor may use his or her knowledge combined with a close watch on the market and a sound understanding of what is happening in the world and its economies to make good financial decisions for clients.
2) Anchoring describes using incomplete or possibly irrelevant information as reference for evaluating or estimating an unknown value of a financial security. For example, should an investor rely on pre-existing information or accept a nugget of learned information to make a final investment decision, he or she has anchored his decision using just the initial value presented.
3) Emotional Gap refers to the decision-making of an investor based on extreme emotions, including, anxiety, anger, fear or excitement. Allowing emotions to play a role in financial decisions may obfuscate an investor’s ability to make sound and rational choices.
4) Mental Accounting is determined designation of money for specific purposes. Many people divide their money and treat it differently depending on which “account” the money is held. For example, money in “savings” can’t be touched or used for anything, even if it means paying down debt. This hard and fast thought process may have unexpected side effects. Mental accounting could veer decisions toward irrational and behavior toward counterproductive. When investing, mental accounting could steer a bias toward selling the winner even though selling the loser may be the rational choice. A realized loss pain may be too difficult to overcome, so the investor may irrationally sell the winner to avoid the pain.
5) Herd Behavior, or “following the crowd,” is a common practice. A number of investors may buy a “hot” stock or sell the “panic” when the market drops, and many individuals tend to follow. Succumbing to herd mentality, investors allow their decisions to be influenced by their peers or trends. As with any trend, many tend to mimic financial behaviors of the majority. Herding, or herd behavior, is infamous in the stock market and has been known to be the cause of dramatic rallies or sell-offs.
Although we may try to avoid how our emotions and biases impact our investment decisions, we must also be cognizant of their existence. Understanding behavioral finance may help investors avoid emotion-driven speculation and irrational decision-making, and possibly avoid investment losses. Devising an investment and wealth management strategy allows investors to thoughtfully plan for a successful financial future and limit reactivity. Historically, long-term investors are more likely to have a higher rate of success than short-term investors, and long-term investors typically avoid innate human biases. We encourage you to speak with your financial advisor to prepare and execute, or reassess, a custom financial plan unique to your goals and outlook for the future.
Thank you for your continued trust in Private Capital Group. We are looking forward to seeing and hearing from you all very soon! We hope that you are staying safe and healthy during these challenging and “new” times.
We send our warm regards to you, your family and all your loved ones and wish you a beautiful and memorable Thanksgiving.
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