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
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