Behavioral Finance and Its Impact on Investors

In 1979, psychologists Daniel Kahneman and Amos Tversky proposed that individual biases can have a significant impact on investors’ behaviors.[1] Around the same time, financial researchers began to realize that long-held beliefs that the stock market behaves in a predictable, rational manner are not always accurate. Instead, markets are often inefficient and unpredictable due to investors’ biases and incorrect beliefs regarding price and risk.[2]

These findings led to an area of study we now refer to as behavioral finance, or the study of how psychological influences can impact investment decisions and market outcomes. Behavioral finance provides us with a framework from which to better understand why we make certain investment decisions and how those decisions can impact future outcomes. An awareness of these biases can help us make more rational decisions, ultimately leading to better financial outcomes.

Common biases

Behavioral finance calls attention to six main investor biases.

1. Herd behavior –This refers to people’s tendency to mimic the financial behaviors of the rest of the “herd.” Herd behavior is often behind otherwise unexplained dramatic rises and falls in the stock market.
2. Mental accounting – Mental accounting refers to the value an individual places on money based on how he or she obtained it. For example, someone who diligently budgets every penny of his paycheck may not hesitate to go on a shopping spree with lottery winnings.
3. Anchoring –Anchoring occurs when an individual subconsciously uses an arbitrary figure as a reference point from which to make a decision. For example, people are likely to assign a higher value to an item if its original price is listed at $200 rather than $60. Anchoring can have a significant impact on investment outcomes if it causes an investor to hold on to an investment that has lost value because he or she is “anchored” in the belief that the investment’s price will return to the arbitrary value the investor has assigned. 
4. Loss aversion –Loss aversion is a tendency to feel losses more acutely than gains. For example, consider an investor who invests an equal amount of money in two separate stocks, stock A and stock B. Stock A grows by 30% and stock B loses 30%. Loss aversion states the investor will feel the pain of losing 30% more acutely than the joy of gaining 30%.
5. Recency bias – This is the belief that recent events will continue into the future. For example, if the markets have been performing well lately, investors are more likely to believe they will continue going up, even if there is no evidence to support that belief.
6. Regret aversion – Regret aversion refers to an investor’s natural desire to avoid regretting a decision in the future. This can lead an investor to make a wrong decision simply to avoid feeling regret. 

How to overcome these biases

The first step in overcoming investing biases is to recognize that they exist. It is natural to believe that our decisions are based on logic and fact, but the sooner we understand we all face biases, the sooner we can improve our decision-making process.

Once you recognize these biases, the following tips can help you avoid them.

• Seek the guidance of a financial professional – One of the best ways to avoid investor biases is by working with a qualified financial advisor. An advisor can help ensure you are making rational decisions that are in line with your long-term goals and objectives.
• Make an investing plan –Working with your financial advisor, make a long-term investing plan and allocate your portfolio accordingly. Your plan should incorporate your specific needs and goals for the future, your risk tolerance, your investment time horizon and any challenges you may face. Use this plan to develop a diversified portfolio that is in line with your goals. Resist the urge to deviate from your asset allocation based on emotion. Instead, schedule regular meetings with your advisor to review your investments and progress toward your goals. During these meetings, your advisor will work with you to make any necessary modifications or adjustments to help ensure your portfolio continues to meet your needs.
• Take a deep breath – One of the best ways to avoid falling victim to your own biases is by taking a deep breath and slowing down. Remind yourself that emotional decisions can be detrimental to your long-term financial security. Take time to make rational, informed decisions. When in doubt, reach out to your financial advisor for guidance.

How United Capital can help

At United Capital, we have seen how investor biases have the potential to derail our clients’ long-term investment goals. That is why we developed MoneyMind®, a tool that helps you understand how you think and feel about money. This understanding can help you make clear, smart choices about your financial life.

Our advisors use this tool to understand your mindset, your views on money and how your life and money connect. They then apply these insights to create a personalized strategy tailored to your values, priorities and beliefs. As your life unfolds, our advisors serve as your partner to help you adjust your strategy, proactively identify opportunities and avoid potential obstacles to your success.  

To learn more about how United Capital Financial Advisors can help you avoid investing biases, please contact us.

[1] https://online.mason.wm.edu/blog/what-is-behavioral-finance

[2] https://www.kaplanfinancial.com/resources/career-advancement/behavioral-finance