“I’m only human.” When was the last time you used that phrase? Possibly when you forgot something, lost something, or made a ‘not so perfect’ decision. “I’m only human” is a phrase in which the person saying it is accepting that they are flawed. So, if we can accept that we are not perfect (at least the majority of us), then why would traditional financial theories follow the assumption that humans (investors) are rational and logical in their decision-making process? Traditional financial theory assumes that investors make decisions by gathering all relevant data and possess the skills to process this information in a rational, unemotional way to arrive at an optimal choice. Rational? Unemotional? Sure doesn’t sound very ‘human’ to me.
On the other hand, behavioral finance draws from real-world experience stating that investors have biases, are irrational, and their emotions play a role in the kind of decisions they make. It combines psychology and economics to explain how investors act. Consider asset bubbles, market crashes, or investors jumping on the band wagon of the latest hot technology IPO. Would these ever take place in a world where everyone is rational, consistent, and has perfect information? I doubt it.
The truth is that we are emotional and make mistakes in our judgements because we are influenced by behavioral biases. Unfortunately, behavioral biases can have a detrimental impact on investment results. It is then crucial for investors to be aware of, understand, and be able to identify the different behavioral biases that may impact their investment decisions.
A Few Examples of Behavioral Biases
- Loss aversion - As humans, we prefer avoiding losses compared to realizing gains. We want to feel secure. It is the idea that you might place greater emotional impact on the fear of loss (and its related negative outcomes) than on the positive outcomes associated with gain.
- Herd Mentality(or the fear of missing out) - If we see a lot of other investors making a decision, we are hardwired to want to follow suit. It is the concept that individuals in a group will tend to follow the actions of others versus making their own decisions.
- Social influence - When you see friends or family making financial decisions that are working out for them, it’s easy to feel like they know what they’re doing, so you should do the same. This is true even if their goals are vastly different from your own.
- Anchoring bias - People have the tendency to rely too much on pre-existing information or the first information they find when making decisions. For example, if you first see a T-shirt that costs $100 – then see a second one that costs $25 – you’re prone to see the second shirt as cheap. The anchor – the first price that you saw – unduly influenced your opinion.
Knowing that these behaviors exist and are part of who you are may help you to create a financial plan that leaves room for how you feel and respond. By understanding the different psychological responses to your emotions, you can attempt to limit this emotional influence on your financial decision-making. Of course, working with a financial advisor can help to ensure you have someone in your corner to act as a sounding board, with the ability to provide discipline and guidance. While most investors have the best intentions when making financial decisions, in the heat of the moment when emotions are elevated, they may have a hard time sticking to their plan. Just remember, you’re only human.