Behavioral Finance Definition: Uses social, cognitive and emotional factors in understanding the economic functions, including consumers, borrowers and investors and their effects on market prices, returns and resource allocation; Primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology with neoclassical economic theory!
Awesome! So what the HECK does that mean?
Let’s start with classical economics. In the olden days most, if not all, economist would agree that we as humans are the most rational beings on the planet and therefore we carry out our lives making well thought out and informed decisions. Because why would we ever act in a way to put ourselves, our families, our wellbeing in jeopardy. Makes sense, right? WRONG!! Think about it, all of us can come up with examples when our emotions have lead us to make IRRATIONAL decisions. For all of the good choices we make there are usually a few that just don’t work out and our emotional reactions are usually to blame. Not only are emotions to blame but also our brains being hard wired to focus on short term gratification and the failure to take a long term perspective.
For example, let’s say you are leaving on a cross country trip from New York City heading to Los Angeles. Should you drive or walk? When leaving New York via the Holland tunnel, where of course there is complete gridlock, walking seems like a great idea. You would absolutely get through the tunnel quicker on foot than by car. But what happens when you reach the other side and 2,780 miles lie between you and LA and you are on foot.
You have a boss that you just can’t stand anymore. You’ve been pushed to the end of your rope and you’re ready to blow up at him and walk out the door. Sure, we have all dreamed of pulling a Jerry Maguire and we can all imagine how great it would feel. But you have to have perspective, long term. The instant gratification of walking out the door and emancipating yourself will feel good only for a short while, that is until you realize what you have just done. You, your family and your wellbeing have just been put into jeopardy by your emotional overreaction and short term perspective.
So how does all of this relate to the title of this week’s blog, Build a Plan and Stop Freaking Out? I think you know where this is going.
When it comes to our hard earned money most people’s rationality and decision making processes go right out the window. Most investors have a tendency to fall victim to:
- Anchoring: Keeping a specific reference point in mind even though it may have no logical relevance. For example, investing $100 in XYZ Stock and watching it grow to $200, your new reference point. Even though the stock has been on a steady decline for years and is now trading at $16 you continue to hold onto it thinking, “I am going to sell as soon as it gets back to $200.”
- Paralysis by Analysis: Not being able to make a decisions because you have too much information available. You continue to run all of your “what if” scenarios meanwhile a decision that wasn’t made effects your long term financial future.
- Mental Accounting: You continue to invest in an emergency fund yet carry high credit card balances. You spend extra money when times are good BUT don’t cut back when something bad occurs. One stock or fund in your portfolio is doing well so the underperforming positions continue to be held despite continued poor returns.
- Confirmation or Herd Mentality Bias: Yes, we are all animals as a matter of fact and can fall victim to herding. For example, “everyone” says it’s a great time to invest so I will. “Everyone” says it’s a bad time to invest, so I won’t. “Real estate will NEVER go down.” “Real estate will NEVER go up again.” “The US Dollar is going to hell, I am investing in Gold.”
- Overconfidence: You were a great investor in the late 1990’s so you quit your job to become a day trader.
- Loss Aversion: The tendency to strongly prefer avoiding losses to acquiring gains - possibly TWICE as powerful. This implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall. There was a study done with Chicago teachers where some of the teachers were paid benefits upfront but could have to pay them back if their student test scores didn’t reach a specified level by the end of the year and another group that received their benefits at the end of the year. Those teachers who received their benefits up front and risked losing their benefits had better results.
So what does all of this mean? Without a doubt Behavioral biases are going to push you off your path. Most of us have the best intentions but our emotions stand in the way of our own financial success. The goal is to NOT get too far off your path that you can’t get back on track.
What should you do?
1. STOP – don’t react too quickly.
2. Have a long term plan and STICK to it. Only makes changes when the facts have changed in a substantial way (you get a promotion, you lose your job, you get divorced, you get married, a child is born, a spouse passes, etc.).
3. ALWAYS set out to attain your short & long term GOALS! Accomplishing even your short term goals helps you keep a better long term perspective.
4. Discuss your impulses to react with your Advisor to help identify the possible culprits.
Without a plan you are destined to make POOR decisions that will affect your long term financial success. Build a plan and work it. Let the plan drive your investment and financial decisions. You’ll be less reactive to the things you have absolutely no control over and even more surprised at how liberated you feel.
BUILD A PLAN AND STOP FREAKING OUT!