How to use this tool
How to use this tool
Investing Driving You Crazy? Maybe Its Because You Already Are!
by Kurt Box (Write for us!)
(Click on the links within the article to get definition of that word)
(Click on the links within the article to get definition of that word)
When it comes to your investments and portfolio, are you overconfident? Are
you just a bit too greedy? Do you panic at signs of a stock market drop, or become elated during latest surge? Do you choose stocks based on vague feelings? Does a 10% loss bring you more disappointment than an 11% gain brings happiness? If you're like most investors, the answer to at least some, if not all, of these questions is yes. (FYI, that includes us! We are just a susceptible to these mistakes, but knowledge is key.)
One of the keys to being a successful investor and reaching your financial goals, both over the long and short term, is being able to understand and control your irrational behavior (which most of us don’t even believe exists in the first place). We all like to think of ourselves as cold, rational and calculating when it comes to our investment portfolio. However, the facts speak much differently. In fact, as we move through a number of irrational behaviors in this and the following articles, we can tell you that we have seen some or all of these behaviors in almost all of our clients. A major part of our job is recognizing these wealth-destroying behaviors, explaining to our clients how and why they are wealth destroyers, then assisting our clients in modifying these behaviors. Of course, and perhaps most critically, we must always be on alert when it comes to our own irrationality. It is just as easy for us to fall into these traps as it is for our clients and other investors, so we must remain ever vigilant.
What is Behavioral Finance?
Much of financial theory is based upon the idea that individuals act rationally and consider ALL available information in their decision-making processes. (Please!!) As this relates to the stock market, individuals in our industry commonly refer to this as the “Efficient Market Hypothesis.”? Surprisingly (though perhaps not, given our other fallibilities), researchers have uncovered an extremely large amount of evidence that this is frequently not the case; that we do not act rationally or consider all available information as this relates to investing and other life decisions. Dozens upon dozens of examples of irrational behavior and repeated errors in judgment have been studied and documented in various academic studies. In fact, in Peter Bernstein’s famous book “Against the Gods”?, Mr. Bernstein states that the evidence uncovered “reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty." Behavioral finance is a field of study that has evolved through attempts to better understand how emotions and illogical and cognitive (cognitive means it is based on empirical factual knowledge) errors influence investors. Both cognitive and emotional biases result in irrational decisions. Cognitive biases stem from faulty reasoning. Cognitive biases often result from the use of “heuristics.”? Heuristics are rules of thumb or strategies used to make a decision when people are overwhelmed by information. This often results in a quick, but typically not optimal, solution. Thus, better information and advice can often correct these cognitive biases. On the other hand, emotional biases originate from impulsive feelings or intuition (as opposed to conscious reasoning) and are thusly much more difficult to correct.
Types of Irrational Behavior and Biases
Some of the various types of cognitive biases include (we will explain and give interesting quizzes/examples of these terms in following articles):
One of the keys to being a successful investor and reaching your financial goals, both over the long and short term, is being able to understand and control your irrational behavior (which most of us don’t even believe exists in the first place). We all like to think of ourselves as cold, rational and calculating when it comes to our investment portfolio. However, the facts speak much differently. In fact, as we move through a number of irrational behaviors in this and the following articles, we can tell you that we have seen some or all of these behaviors in almost all of our clients. A major part of our job is recognizing these wealth-destroying behaviors, explaining to our clients how and why they are wealth destroyers, then assisting our clients in modifying these behaviors. Of course, and perhaps most critically, we must always be on alert when it comes to our own irrationality. It is just as easy for us to fall into these traps as it is for our clients and other investors, so we must remain ever vigilant.
What is Behavioral Finance?
Much of financial theory is based upon the idea that individuals act rationally and consider ALL available information in their decision-making processes. (Please!!) As this relates to the stock market, individuals in our industry commonly refer to this as the “Efficient Market Hypothesis.”? Surprisingly (though perhaps not, given our other fallibilities), researchers have uncovered an extremely large amount of evidence that this is frequently not the case; that we do not act rationally or consider all available information as this relates to investing and other life decisions. Dozens upon dozens of examples of irrational behavior and repeated errors in judgment have been studied and documented in various academic studies. In fact, in Peter Bernstein’s famous book “Against the Gods”?, Mr. Bernstein states that the evidence uncovered “reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty." Behavioral finance is a field of study that has evolved through attempts to better understand how emotions and illogical and cognitive (cognitive means it is based on empirical factual knowledge) errors influence investors. Both cognitive and emotional biases result in irrational decisions. Cognitive biases stem from faulty reasoning. Cognitive biases often result from the use of “heuristics.”? Heuristics are rules of thumb or strategies used to make a decision when people are overwhelmed by information. This often results in a quick, but typically not optimal, solution. Thus, better information and advice can often correct these cognitive biases. On the other hand, emotional biases originate from impulsive feelings or intuition (as opposed to conscious reasoning) and are thusly much more difficult to correct.
Types of Irrational Behavior and Biases
Some of the various types of cognitive biases include (we will explain and give interesting quizzes/examples of these terms in following articles):
- Anchoring and adjustment
- Availability
- Representativeness
- Selective memory
- Overconfidence
- Mental accounting
- Regret
- Lack of self-control
- Loss aversion
- Hindsight
- Denial
- Herding or groupthink
- Fear and greed
Email this Article
Print this Article
Cite this Article
Other Suggested Articles
Evaluating Potential Stock Investments >
The CANSLIM Stock Strategy >
Buy and Hold Stock Strategy >
Dollar Cost Averaging Stock Strategy >
Short Selling >
Buying Stocks Using Growth Strategy >
Understanding GARP Stock Investing Strategy >
Choosing a Stock >
Basics of The Value Investing Stock Strategy >
Market Timing Strategy of Buying Stock >
Other Articles By This Author
Investing Driving You Crazy? Maybe Its Because You Already Are! (Part 3) >
Putting Risk in Its Place in Your Portfolio (Part 4) >
Should You Use More Than One Financial Advisor? >
College Savings Plans: The Benefits of a 529 Plan >
Beneficiary Designation Planning: Not As Simple As You Think >
Putting Risk in Its Place in Your Portfolio (Part 1) >
Putting Risk in Its Place in Your Portfolio (Part 3) >
Portfolio Rebalancing vs. Market Timing >
Investing Driving You Crazy? Maybe Its Because You Already Are! (Part 4) >
Article reprinted with permission. Unauthorized reproduction of this content is prohibited.
Click here to license InvestorGuide University content.
Click here to license InvestorGuide University content.
