Behavioral Finance

Published On: July 26, 2018

Written by: Ben Atwater and Matt Malick

“Discipline is the bridge between goals and accomplishment.” – Jim Rohn

Behavioral Finance is the branch of economics concerned with instances where emotion and psychology have undue influence upon decisions, resulting in rational actors displaying unpredictable behaviors.  Behavioral Finance combines behavioral and cognitive psychological theory with conventional economic theory in order to help explain why people might make irrational financial decisions.

When it comes to investing, the returns that the average investor experiences are far below those of relevant benchmarks.  For example, according to the study, Dalbar’s Quantitative Analysis of Investor Behavior 2016, a benchmark consisting 50% of the Standard and Poor’s 500 Stock Index and 50% of the Bloomberg Barclays U.S. Aggregate Bond Index had an average annual return of 6.77% from 1996 through 2015, while the average asset allocation fund investor had a return of 2.11% per year.  Experts believe this enormous gap between the benchmark and actual investor performance is due to behavioral finance shortcomings.

Experiments by Daniel Kahneman and Amos Tversky, who were the subject of the Michael Lewis book The Undoing Project: A Friendship That Changed Our Minds, find that people chose to take a risk only when the perceived potential gain is two times greater than the expected loss.  This causes people to buy when things are good and people are optimistic (assets are expensive) and to sell when things are bad and people are pessimistic (assets are cheap).

Poor decisions also stem from information overload.  The Pew Research Center found that the average person checks their cell phone 150 times per day.  Meanwhile, GlobalWebIndex surveys say that the average social media consumer spends two hours per day on various applications.  And speaking of apps, iTunes alone has 240 financial apps ready for download.

And the more market volatility we experience, the more people seek information.  From 2000 through 2015 the S&P 500 has seen 192 trading days where the market fell more than 2%.  This compares to a total of 174 days from 1947 through 1999.  In other words, in the recent past, the market has been more volatile in 15 years that it was over 25 previous years.

Having emotional distance between you and your investments is a wise decision.  The 2016 Fidelity Millionaire Outlook survey found that 62% of investors seek the advice of a financial advisor.  Advisors should create an investment plan consistent with your retirement goals and risk tolerance; offer discipline and consistency; and guide you through the emotions of investing and of broader financial decisions.

Advisors can further alleviate poor behavioral tendencies through other techniques.  First, establishing what should be a long-term relationship with a highly trusted advisor allows the advisor to better know and understand you.  By regularly updating your retirement and investment plan and, at the same time, maintaining a highly disciplined investment process, an advisor can help you stay focused on the long-term.  And, finally, perhaps an advisors’ most important job, to prevent panic selling by preparing you for and then staying invested during times of market volatility and uncertainty.

If you have any sense of hesitation about your long-term financial and investment plan, please get in touch with us and we will meet to review your personal strategy.

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