Your emotions may be getting in the way of building wealth.
In a study published in the Journal of Financial Planning, individuals who leveraged a behavior-modified approach that removed emotion from their investing saw upwards of 23% higher returns over the course of 10 years.
So today we will be exploring 10 behavioral finance concepts to better understand how we can limit our emotion’s role in our investment decisions.
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What is Behavioral Finance?
In order to understand what Behavioral Finance is, we first need to understand Traditional Finance Theory.
Traditional Finance Theory is comprised of three core assumptions:
- Individuals have complete self control
- Individuals understand all available data prior to making decisions
- Individuals are always consistent in their decision making
In a nutshell, Traditional Finance Theory states that individuals consistently make rational decisions solely based on the objective facts that are available.
However, humans are not always rational. In reality:
- We don’t have always self control
- We don’t always have time to understand all the data prior to making a decision
- We are not always consistent with our decisions.
As a result, Behavioral Finance diverges from Traditional Finance Theory by emphasizing the role that psychology plays in individual behavior.
Therefore, Behavioral Finance is the concept that we are vulnerable to making sub-optimal decisions due to a variety of psychological influences that introduce emotion into our decision-making.
In other words, we are capable of making irrational financial decisions 🙂
Why is Behavioral Finance Important?
As we saw earlier, our emotions can have a substantial impact on our ability to build wealth.
By understanding the different psychological responses to our emotions, we can attempt to limit this emotional influence on our financial decision-making.
So let’s now explore 10 behavioral finance concepts that can impact our finances.
10 Behavioral Finance Concepts with Examples
Loss Aversion is the idea that there is a greater emotional impact associated with losses versus gains.
Said another way, when given the choice, individuals will prefer avoiding losses vs realizing gains.
As an example, let’s say that we invested in a particular stock.
The concept of loss aversion suggests that we are more willing to sell the stock if it decreased 20% in value as opposed to if it gained 20% in value.
This is despite the fact that buying more of the stock, once it’s value has decreased, will actually lower our average cost of purchase.
Representative bias is the tendency for individuals to make judgements based around their previous experiences.
As a result, similarity to past experiences will have a greater impact in someone’s mind vs. the actual probability of the event occurring.
As an example, let’s assume that we were one of the lucky few who invested early in Amazon. We would have made some stellar returns.
As a result, this could create a representative bias in our minds that investing in technology companies is the only way get those types of returns.
Furthermore, let’s imagine that we are given the choice between investing in a technology company with mediocre growth and a construction company with great growth.
Representative bias would push our investing preference towards investing in the technology company because of our past investment gains associated with the technology sector.
Overconfidence & Illusion of Control
Overconfidence is the ego-driven belief that individuals overestimate their knowledge on a topic and believe they have an edge over everyone else.
As an example, let’s assume that we decided to trade stocks.
We develop a hot streak that results in some excellent returns. As a result, we may now believe that we have cracked the code to beat the market are in control.
However, this overconfidence and the illusion of control can be dangerous.
Overconfidence leads to us becoming more comfortable with taking on riskier bets – thereby increasing our odds of losing larger amounts of money.
This overconfidence can be avoided by objectively understanding risks of potential investments.
Don’t be like DJ Khaled and think you can win win win no matter what 🙂
Confirmation Bias is the idea that individuals tend to seek information confirming their existing opinions while ignoring information that may be contrary to those beliefs.
Confirmation Bias results in:
- Limiting the data used to make a decision
- Hindering our ability to objectively evaluate the situation
To illustrate an example, I’m going to pick on Tesla.
If we believed that Tesla would make a great investment, then reading an article like “Tesla’s rise made 2020 the year the U.S. auto industry went electric” could confirm our opinion and solidify our decision to purchase Tesla stock.
At the same time, we may be less inclined to read an article such as “Tesla’s Profits Are Not From Selling Cars.”
By only actively choosing to read information focusing on the positives of an investment, we miss the opportunity to analyze potential risks associated with that investment.
While it is difficult to do, we can avoid this bias by making it a priority in understanding the good, the bad, and the ugly of an investment in order to make an objective determination – what are the facts?
Anchoring Bias is the idea that individuals are fixated on particular pieces of information and use that as the reference point for making judgements.
An individual’s decision-making is therefore said to be anchored to these psychological benchmarks.
Let’s assume that a potential investment that we were considering hits an all time high.
At this point, we may not want to invest because we are now “buying at the top.”
In this case, we are anchored to that current all-time high price and now have a fear (loss aversion) that investing at that price will guarantee losing our ass.
This is despite research showing that time in the market beats market timing.
If someone were to have believed the market was over priced back in 2010, they would have missed out on some amazing returns.
Herding Mentality is the concept that individuals in a group will tend to follow the actions of others vs making their own decisions.
My favorite example of herding mentality was the recent r/WallStreetBets Game Stop short squeeze.
The meteoric rise in Game Stop’s stock price from $2.57 to $483.00 wasn’t based on changes in the company’s fundamentals.
Instead, it was the result of a bunch of folks from Reddit banding together to send Game Stop “to the moon!”
Framing is the idea that individuals are influenced by the context surrounding the options available.
In other words, how something is presented – positively or negatively – can have a drastic impact on an individual’s decision.
Imagine that I showed you this unnamed stock’s price history.
Looks like a great investment right?
However, I cherry-picked the time frame to show the Game Stop short squeeze that we talked about earlier.
When looking at Game Stop’s stock price history, we may not be as inclined to make a long term investment in Game Stop.
Hindsight Bias is also referred to “Knew it all along Syndrome.”
It is the idea that after an event has occurred, individuals who correctly predicted an event now believe they are able to predict similar events.
Hindsight Bias can be a precursor to an individual developing an overconfidence bias.
As a result, we will return to the example we used for the overconfidence bias:
We have developed a hot streak trading stocks. We now believe that we cracked the code to beat the market and are absolutely in control.
However, past performance does not predict future performance.
With close to an infinite amount variables impacting the stock market, it’s highly unlikely that we could ever perfectly replicate an event as it happened before.
The Narrative Fallacy
The Narrative Fallacy is the tendency for individuals to link unrelated or incomplete facts together to explain a situation.
Psychologically speaking, our brains are wired to identify a cause-and-effect relationship.
An example of this are news articles with headlines reading “The S&P 500 hit a new all time high because of X”.
The reality is there are a near infinite amount of reasons on why the S&P 500 could hit an all time high.
To state that one variable is the single reason for the S&P 500 hitting an all time high would be extremely shortsighted.
However, that type of headline satisfies our brain’s mission to quickly identify a cause and effect relationship in order to understand the situation – oversimplifying the situation.
Self Attribution Bias
The Self Attribution Bias is the idea that individuals attribute positive events due to their own skills and negative events due to things beyond their control.
Individuals who are impacted by this bias are less willing to learn from or accept their mistakes.
They are therefore at a greater risk of repeating those same events and possibly losing more money.
As an example, imagine that somebody lost a lot of money on a particular stock.
Instead of acknowledging and learning from that loss, they may attribute that loss to something like:
“There was a glitch with my brokerage account that made me be buy higher then I wanted to… so they are the reason why I lost money when I sold.”
In reality – when it comes to investing – the only thing that we can control is what we buy and sell.
It’s pretty amazing to see how irrational we can be with our finances.
Writing this post has made me reflect on how some of my own decisions have been impacted one way or another by each one of these psychological biases.
If you are interesting in learning about more about these behavioral finance concepts, I recommend checking out The Psychology of Investing by John Nofsinger.
Thank you for reading! 🙂
Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my page for a full disclaimer.
As a seasoned financial expert with a deep understanding of behavioral finance, I'd like to delve into the intriguing study mentioned in the article and provide an insightful exploration of the 10 behavioral finance concepts highlighted to help investors limit the impact of emotions on their financial decisions.
The study cited in the article, published in the Journal of Financial Planning, underscores the significance of adopting a behavior-modified approach that removes emotion from investing. According to the study, individuals who embraced this approach experienced significantly higher returns—upwards of 23%—over a 10-year period. This compelling evidence demonstrates the tangible benefits of understanding and mitigating emotional influences on investment decisions.
Now, let's delve into the 10 behavioral finance concepts presented in the article:
- Defined as the concept that psychological factors play a crucial role in individual behavior, especially when making financial decisions.
Traditional Finance Theory:
- Three core assumptions: complete self-control, understanding all available data, and consistency in decision-making.
- Highlights the rational decision-making based on objective facts.
- The idea that individuals prefer avoiding losses over realizing gains.
- Example: Selling a stock at a 20% loss rather than waiting for it to recover, despite the potential for lower average cost.
- The tendency to make judgments based on past experiences, leading to biased decision-making.
- Example: Investing in technology companies due to past successful experiences, ignoring other sectors.
Overconfidence & Illusion of Control:
- Overestimating one's knowledge and control, leading to risky decisions.
- Example: Believing to have cracked the market code after a successful streak, resulting in increased risk-taking.
- Seeking information that confirms existing opinions while disregarding contrary information.
- Example: Focusing on positive news about an investment while neglecting potential risks.
- Fixating on specific information as a reference point for judgments.
- Example: Avoiding an investment at an all-time high due to fear, despite market timing evidence.
- Individuals in a group tend to follow others' actions instead of making independent decisions.
- Example: The r/WallStreetBets Game Stop short squeeze driven by collective actions.
- Decision-making influenced by how options are presented.
- Example: Presenting stock price history selectively to influence investment decisions.
- Believing one could predict events after they have occurred.
- Example: Assuming past success in trading indicates future predictability.
- Linking unrelated or incomplete facts to create a cause-and-effect explanation.
- Example: attributing a market high to a single variable when various factors contribute.
Self Attribution Bias:
- Attributing positive events to personal skills and negative events to external factors.
- Example: Blaming a brokerage glitch for a loss instead of learning from the decision.
In conclusion, understanding these behavioral finance concepts is crucial for investors seeking to make informed and rational financial decisions. By recognizing and addressing these biases, individuals can enhance their ability to navigate the complexities of the market and, as the study suggests, potentially achieve higher returns over time.