Understanding Behavioral Finance

What is your first instinct when you see the news headlines warning of an impending market drop? What about when you see a stock’s name being praised as a winner week after week? Most likely your initial reaction is one based off emotion, not logic. And that is perfectly normal!

This is due to the scientific fact that we are physiologically hardwired to process information sent through our brain’s “emotional center” (the limbic system and amygdala) before it goes through our brain’s “rational center” (the prefrontal cortex). In fact, our emotional reactions are instinctively more than three times faster than our rational reactions.

So, what exactly is behavioral finance? Fidelity Investments defines behavioral finance as “the intersection of behavioral psychology and finance that helps explain why people can make irrational financial decisions”. It combines physiological, psychological and economical philosophies to help decipher certain human behaviors.

Why is this important and how does it affect you? Simply because we are humans, not computers. We use our personal knowledge and past experiences for our decision making. We also live in a modern world where we have access to an unlimited amount of information (both reliable and unreliable) at any given moment. We make countless decisions every day from the moment we wake up until we go to sleep at night. (And sometimes during sleep hence the phrase ”I’ll sleep on it.”)

In order to avoid constantly feeling overloaded, our brains use mental shortcuts called biases to alleviate some of the work from all the decisions we have to make. Often times, these biases are helpful and save us time so that we can focus on making the bigger, more important decisions we need to make in life. However, at other times we let outside influences, people or biases impact logical decision making. When it comes to finance, making a decision based on emotion or allowing other factors to influence us can be costly.

Here are some of the most common mental biases in relation to behavioral finance:

Overconfidence: At times, past success or luck can lead us to feel more confident in our ability than we may actually be and can lead us to overestimate our own skills. This can lead to ignoring conflicting information or advice. While confidence is a positive attribute, overconfidence can impair rational decision making.

• Example: “The last stock I picked was a winner, this next one will be too. I just know it.”

Excessive Optimism: Sometimes we look at the glass half full and other times we look at the glass half empty. A pessimistic view can help us be more aware of what might go wrong in a situation, but can fail to allow you to envision a positive outcome. An overly optimistic view can lead us to overlook the risks or realities of a particular financial investment or decision. Oftentimes, we actively avoid thinking about bad outcomes because we don’t want to have to deal with it. Because we don’t know if or when something might happen, we kid ourselves that it never will happen.

• Example: “I’ll wait to have my estate planning documents finalized. The chances of anything bad happening on my trip are slim to none.”

Confirmation Bias: This mental bias happens when we only seek out information from sources we know will validate our thoughts and beliefs. Keeping your mind open to other sources of information might offer you a new perspective to make a more informed, well-rounded choice.

• Example: “My friend assured me that the mutual fund she showed me is the best to choose for my retirement account and I trust him/her.”

Familiarity Bias: This is the tendency to make a decision based on personal prior experience. Choosing what we already know often feels more comfortable than treading into new territory. You may feel more averse to different options because they are new and therefore unfamiliar.

• Example: “I have always had my insurances through XYZ Company, so I am sure that they must be offering me the best coverage at the best rates.”

In order to avoid making irrational financial decisions, you can become aware of some of the most common mental biases mentioned above. Another great way to avoid making costly mistakes based on emotion or biases is by taking full advantage of having a financial advisor who abides by the fiduciary rule. One of the greatest advantages of having a trusted financial advisor is their ability to be a reliable source, look out for your best interests, and help take the emotions of out of financial decision making.

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