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InvestorGuide University > Subject: saving > Behavioral Finance

Economic Trends
Behavioral Finance
by Michael Chadwick (Write for us!)
(Click on the links within the article to get definition of that word)

An industry leading research firm, DALBAR, reports that investors have certain behaviors which lead them to buy, sell and switch in and out of mutual funds. They just produced a study called the Quantitative Analysis of Investor Behavior (QAIB) and I'd like to share some of the main points with you so you'll hopefully avoid these pitfalls.

The investor's behavior is the number one determinant in performance over the long haul as it relates to investments. There are terms that define the pitfalls many of us fall into and here are there definitions. "Loss aversion" is expecting to find high returns with low risk. Unfortunately these two things are diametrically opposed and do not exist. If you hear of such a thing, run in the opposite direction. "Narrow framing" is making decisions without considering all of the implications. I see this not just in finance, but in many areas of our lives. Consult a professional prior to running wild with your nest egg - or more importantly someone else's.

"Anchoring" is relating to familiar experiences - even when they're inappropriate. If your neighbor is a successful investor you won't necessarily be too - tread with caution here, it's comfortable and natural to anchor - but it'll kill your investment results. "Mental accounting" is where people take undue risk in certain areas and avoid rational risk in others. This is akin to keeping your investments in fixed accounts and visiting the casino to make money - you wouldn't believe how much of this we see - and from what professions.

"Diversification" is seeking to reduce risk, but simply using different sources. This is where people own 11 different mutual funds - all doing the same things. More isn't always better and be sure you are truly diversified within your holdings, not just with a lot of holdings.

"Herding" is where you copy the behavior of others even in the face of unfavorable outcomes. Perhaps selling when things get ugly and buying what feels good - did you buy real estate in last few years - if yes you're guilty.

"Regret" is when you treat errors of commission more seriously then errors of omission. What you didn't know can not only hurt you - it can cripple you financially.

"Media Response" vis when people react to media announcements. When quarterly earnings or splits come out - is a company really worth 5, 10, 15, 20% more or less than it was the day before? NO! Don't fall prey to the media response.

Lastly - "Optimism" is when people believe that good things happen to me and bad things happen to others. This one will bankrupt you too - akin to the belief that casinos don't make money and lottery is not a voluntary income tax.

All of these behaviors will not only erode your savings and cripple you financially - they'll make the rest of your life miserable too. Our lives are so much better if there are no financial stresses. The stress comes from the lack of a plan. We'll help you moderate your behavior and do what needs to be done intellectually and economically, not emotionally.