One of the most interesting topics in finance in recent years is the idea of investor psychology, also referred to as behavioral finance.
Like so many aspects of the human condition, analyzing why we make the financial choices we do is fascinating, and the roots go deeper than many of us imagine.
While there are many helpful findings in the Behavioral Finance field, here are four that might help you avoid financial pitfalls we all face:
1. Present Bias
Simply put, human beings like to feel good now. Whether it is splurging on a cup of coffee or building up credit card debt from overspending, we like to enjoy things in the present – often at the expense of future benefits.
This is especially evident when it comes to saving and investing, as the fruits of these labors are not typically enjoyed until retirement! It’s also why the act of holding off just this once can help you make better decisions for your long-term future.
Animals of all stripes tend to move in herds. This strategy confers certain benefits: putting their heads together, they’ll be better protected from predators, and more likely to find their next meal.
As investors, following the herd can be dangerous. The “herd mentality” can cause us to throw caution to the wind and behave irrationally – which we tend to realize after the fact.
For a fascinating historical example, Google the Tulip Market Crash of 1637. More recently, similar investor behavior has helped bring about the Dotcom Bubble burst some 20 years ago, and the housing market crash of 10 years ago.
3. Availability Bias
Speaking of…remember the Global Recession of 2008? The availability bias plays on our tendency to become disproportionately influenced by recent, traumatic, or personally relevant experiences.
Modern media doesn’t help, as sensational, often negative, headlines dominate the news cycle. Consider this: you are far more likely to hear stories of investors who lost it all or struck it rich than to hear about the average person who saved diligently throughout their career and rode their IRA and 401k to retirement success.
Use this bias to your advantage! The next time you hear about someone losing it all, put an extra few hundred in your savings account to avoid future catastrophe!
As a side note, I outline 5 ways you can be better prepared for retirement in a previous post.
4. Loss Aversion
Perhaps the most influential investor behavior, this describes the phenomenon people generally feel more pain from loss or failure than they feel joy from success.
In finance this most commonly results in inefficient use of our assets, or, more simply, our tendency to sit on “safe” cash that earns nothing instead of investing for the long term.
If you have more than 6 months’ expenses already saved, it may be wise to invest some of your cash. Schedule a consultation with a Unitus Financial Advisor to see if you can get more out of your money.
The odds are good that we can see ourselves in some, if not all, of these examples. But in a world where our retirement success is increasingly dependent on the financial choices we make now, it is more important than ever to analyze our own instincts in investing.
How can you avoid some of these pitfalls? Develop partnerships with advisors who can help navigate these deep-rooted tendencies and guide you through the tough times.
Contact Shelly Geweke. Financial Advisor Coordinator at 503.423.8519 or firstname.lastname@example.org to set up a complimentary, no-obligation consultation.
Posted by: Todd Micciche
About the Author: Todd Micciche, a financial advisor like his father before him, is driven by the positive change he has seen in the lives of his clients. He earned his MBA at Portland State University and has built 12 years of experience advising clients to help them reach their specific financial goals. He holds various FINRA securities registrations and is currently studying to attain CFP® certification.
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