Humans aren't robots. While the fields of economics and finance were built on models that assumed entirely rational decision-making, research has found that's rarely the case.
Humans behave irrationally and make emotional decisions about money and investing all the time. That's what the emerging field of behavioral finance is all about.
On Wall Street, every investor is above average. Or at least they think they are. One study found that 74% of managers thought they were above average, which isn't actually statistically possible.1
Stay humble. Overconfidence can lead to you thinking you've got an edge on the market and push you into risky investing behavior. When markets turn, you can suffer losses that really hurt your long-term finances.
Losing money in the market hurts. Research shows that loss aversion is even more powerful than your desire for market gains.
The psychological pressure to sell out of a falling market and avoid further loss can be intense - don't underestimate it. However, the cost of emotional selling is that you both lock in the losses and can miss out on the market rebound. Loss aversion can also cause you to hold on to portfolio losers longer than you should.
The solution? Acknowledge your emotions around selling, but let logic guide your decisions. Rely on your financial professional's advice when you're feeling emotional about your investments.
Framing is a cognitive bias that influences how we respond to choices and events based on how they are presented to us. The concept is critical in the financial world because we frequently frame gains and losses around benchmarks and time periods.
For example, if you learned that your portfolio was down 3% for the year, you might be unhappy. But, if you realized that your portfolio was up 18% over the last two years, you might feel differently.
That's the power of framing.
When you're dealing with unpredictable markets, take the opportunity to frame portfolio performance a different way: "Am I making progress toward my financial goals?"
Recency bias leads us to think that whatever has happened recently is likely to continue. So, when markets are performing well, we think they'll rise forever. When markets fall, we think they'll keep falling. When a crisis strikes, we fear another is just around the corner.
Fight back by reminding yourself that bull markets inevitably end and that market crises typically recover.
Anchoring is your brain's tendency to focus on the first piece of information it receives and use it to make subsequent decisions. When you see a discount tag next to a full price, your brain anchors on the money saved (whether the final price is actually fair or not).
Anchoring can affect big financial decisions by causing you to fixate on a single data point - like the price you paid for your house or a recent stock price spike - and disregard other information about value.
The best defense against anchoring is to think critically and to seek multiple perspectives on the value and future potential of your investments.
Nobel prize winner Daniel Kahneman identified the brain's two modes for thinking.2 System 1 (Fast) is intuitive and good at making snap decisions using the amygdala. Great for ordering at the bar. Not so great for making investment decisions. System 2 (Slow) is for deep analysis and is associated with the rational prefrontal cortex.
Whenever numbers are involved, slow down so your brain has time to engage the deep thinking required to make smart decisions. You're likely to make fewer mistakes than you would using intuition.
Want to learn more about neuroeconomics? Read Kahneman's book, Thinking Fast and Slow.
Our understanding of how the human brain functions and how we make financial decisions is constantly improving. Part of staying current in my field is learning about psychology and behavioral finance, and using what I know to help my clients.
I help my clients create smarter behaviors by being an objective accountability partner to help talk through emotional decisions. I'm also there when markets are turbulent; my job is to be the voice of rationality and calm when investors feel like the sky is falling.
If you have questions about the behavioral side of finance or want to learn more about the psychology of money, please reach out. I'd be happy to talk to you and recommend some books I've found helpful.
Feeling emotional about your finances or how events are affecting your investments? Give me a call as soon as you can at (415) 917-3202, I'm here to help.
Thanks for reading,
Entrefolio Wealth Management