Behavioral Finance: How Investors Really Think

Too often we humans think we are 100% rational. We believe we’re able to sift through the market data and make informed decisions about our investments. Unfortunately, that is not the case. After all, we are still human – swayed by emotions, authority, rationality, and other unseen factors.

The science that studies these psychological aspects of financial decision-making is behavioral finance. We define behavioral finance as:

A field of finance that uses psychological theories to help explain stock market actions. We understand that market participants always influence individuals’ investment decisions and market outcomes. We understand behavioral finance is not the only aspect affecting the market, but it is a critical part to modern investment theory.

We’ve discussed behavioral finance before. Yet this field is so important to investment planning that it’s worth a review. In fact, behavioral finance is one of the pillars of investment theory.  If investors were computers, then emotions and common deceptions wouldn’t sway our financial decisions – but we are not computers. We have brains influenced by the ever-present fear and greed in the market.

Last week, we mentioned a recent Dalbar study of investor behavior. The report highlighted several aspects of behavioral finance worth repeating. Here are nine aspects of behavioral finance that affect every investor:

• Loss Aversion: Expecting big returns with low risk.
• Narrow Framing: Making decisions without considering all the implications.
• Anchoring: Relating to familiar experiences, even when inappropriate.
• Mental Accounting: Taking undue risk in one area while avoiding rational risk in others.
• Diversification: Trying to reduce risk by simply using different sources, giving no thought to how such sources interact.
• Herding: Copying the behavior of others even in the face of unfavorable outcomes.
• Regret: Treating errors of commission even more seriously than errors of omission.
• Media Response: Reacting to news without reasonable examination.
• Optimism: Believing that good things happen to “me” and bad things happen to “others”.

We are all affected by these habits – some more than others. However, by becoming aware of our investing propensities we can often recognize when we might be slipping into a bad habit.

A more tangible use of the list is to print it out. Whenever you’re ready to buy or sell, ask yourself if you are irrationally slipping into a psychological error. This won’t keep you out of every bad trade, but it will serve as a check on your investing decisions – and make you a more balanced investor.