Understanding behavioral finance can give you the edge
Behavioral finance uses theoretical and empirical academic research to explain why investors often fail to act rationally.
Understanding both the “how” and the “why” of irrational investor behavior can save you millions over a lifetime.
Research shows that many individuals are overconfident, under-diversified, short-sighted and easily swayed by the media.
If the world were full of “rational” individuals who could maximize their wealth while minimizing risk, there would be no need for wealth advisors. Rational individuals would assess their risk tolerance and then determine an investment portfolio that met their ideal level of risk aversion. However, we know that most individuals are not capable of being 100-percent rational, especially during times of stress. That’s why it’s so important to have a trusted coach, guide, consigliere or voice of reason to prevent you from being your own worst financial decision-making enemy.
Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain why people, especially investors, do not act in a rational manner. Understanding behavioral finance can be invaluable to your investing and wealth building success. Think of the moniker “behavioral” as describing how and why individuals behave the way they do.
First let’s look at the “how.” Here are some findings, based on empirical research, that explain how investors tend to behave when they don’t have expert guidance to help them:
They invest in under-diversified portfolios.
They trade actively with high turnover and high transaction costs, which causes a significant drag on returns.
They are influenced by where they work and live. They invest heavily in the stock of their employers, and they tend to invest in stock of companies based in their home country, and even in companies located near where they live.
They are often influenced by companies that receive lots of media attention.
They tend to buy, rather than sell, companies that are mentioned positively in the news.
They tend to sell their winning investments, while holding on to their losing investments way too long in the inevitable chase to get back to “breakeven.”
Men tend to trade more often than women do. The turnover and costs associated with active trading explains why men tend to achieve lower absolute returns on their money than women do.
Now let’s look at why individuals behave a certain way, which is based on theoretical research. Here are some theories:
Psychological research supports the theory that individuals are generally overconfident. This hubris explains why investors tend to trade too actively and to have dangerously under-diversified portfolios.
Research supports the theory that most investors believe they are “better than the average” investors, which makes about half the population delusional, not to mention overconfident.
Psychological research supports the theory that investing in stocks is a sensation-seeking activity for many individuals. It’s a form of entertainment and it provides many individuals with an adrenaline rush that’s akin to the thrill people get from gambling.
Behavioral finance literature serves as a reminder of why it is so important to protect yourself from your ego and emotions. That’s where a truly objective advisor with your best interests in mind comes in. The appropriate stewardship of your wealth is a responsibility to yourself, to your family, to your house of worship, your community and your country. As with so many things in life, enjoy your wealth, but do so responsibly. Don’t try to do it yourself.
If you or someone close to you has concerns about their financial decision-making process, please don’t hesitate to contact me. I’m happy to help.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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