One field of finance has been growing in coverage over the years which I believe influences investment outcomes more than any other factor. Yet, many investors think market drops and bad investments are what cost folks the most.The real reason people fall short of financial goals, in my opinion, is based heavily on this field of “behavioral finance.” There are several ways behavioral finance can influence our investing and financial decisions, this article explores some of reasoning and how investors can beware of such behavior.
Scenario One
A concert is coming up where one of your favorite bands will be playing. When the tickets go on sale you choose to pay more to get good seats. Let’s say they cost $100 each and you buy two tickets. As the concert date approaches you check the weather and see that there is a good chance of rain showers the night of this outdoor concert.
Are you going to tough out the weather and go to the concert? Probably.
Scenario Two
This same concert is coming to town but instead of buying the tickets you end up winning the same $100 tickets from a radio prize. They mail you the tickets and then as the date approaches you begin to check the weather. You see rain is in the forecast just like in Scenario One.
Are you as likely to sit out in the rain in this scenario? Maybe not.
The tickets have the same financial and entertainment values. However, paying hard earned money for the tickets changes withway people view them compared to the ‘free’ tickets that were given to them.
Effects of Behavioral Finance
Let’s apply this concept to a common personal finance challenge. I have found that investors place a stronger emotional attachment to money saved outside of retirement accounts versus the money accumulated in 401ks. This tends to be true especially if retirement is ten or more years away, and the 401k contributions accumulate automatically and the company usually matches on top so there’s less perceived sacrifices to grow this account.
What happens when we look at investing that rainy day fund for the same investor? It is much more difficult to invest that cash because of all the sacrifices that were made in order to accumulate the account. The savings account represents all the nights eating in, the vacations skipped and so on.
Let’s put taxes aside for a moment. A $250,000 401k balance is worth the same as a $250,000 savings account, right? Then why does the savings account mean more to nearly all investors. Mental accounting is the reason the same person can view similar dollar amounts in different ways.
Another example of behavioralfinance is confirmation bias. This is where investors will believe a certain idea about an investment and tune out information that conflicts with this concept. For example, if someone is afraid of the market dropping, perhaps right before they plan to retire, they will read articles about a pending recession and watch the news clips about how the economy is slowing. Subconsciously they will avoid reading positive market commentary or anything that goes against their underlying bias.
We need to be aware of these games we sometimes play in our heads. Many times we are just too close to the issue at hand, which causes emotions to be high and the likelihood of mistakes to increase as well.
How can we prevent mistakes based on behavioral decisions?
The first of two steps to help protect us from our own behavior is to have a long-term plan. Many investors focus too much on the short term market movements and portfolio returns. The real focus should be our long-term goals and if our portfolios are aligned to help us achieve them. A bad month, quarter or year should not jeopardize one’s overall financial plan.
The second, and equally important step, is to have a sounding board when making large financial decisions:someone to help draw out the underlying reasons for a financial decision and view the choice from different angles. Make sure the person is independent and can put your interest first.
As with most topics as complex as personal finance and investing, consider hiring a professional. Hiring a professional instantly taps you into years of experience and hundreds or thousands of unique financial decisions. This wealth of knowledge should translate to your personal wealth when stretched over a lifetime.
While we can’t change human emotions, we can be aware of them. Try to use them to your advantage when it comes to personal finance.
Joseph Conroy, CFP, is a financial advisor at Synergy Financial Groupin Towson and the author of “Decades & Decisions: Financial Planning At Any Age.”
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through SFG Wealth Management, a registered investment advisor. SFG Wealth Management and Synergy Financial Group are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal.
