Presented by: Michael Sayre

Transcript

Introduction

The average American spends about a third of their life sleeping and about a third working. That's a lot of time spent working. So, with so much of our lives dedicated to earning money, we must understand how to make the most of our money. In other words, you work hard for your money. Let's ensure that your money is working hard for you and that you can avoid those things that erode wealth over time.

My name is Michael Sayre. I am a financial advisor here at CUI Wealth Management. And let's talk about some of the fundamental principles and concepts of finance. This is one of many videos we've created to discuss financial principles. We'll cover some of the basics to help you make better decisions. But don't worry; we don't want to bore you to death with numbers or make you feel guilty about your coffee habit. We might do that a little bit here and there.

We aim to help you make those small changes that can produce significant results over time. Personal finance is about making smarter decisions with your money. Choices that provide you with more freedom, less stress, and the ability to enjoy the things that you love without consistently worrying about the next bill. Concepts like budgeting might sound like they're about as exciting as watching paint dry, but hear me out: without a solid grasp of financial fundamentals,

We are essentially prone to fly blind. And while that might get us by, we can do much better. Some fundamental concepts we need to understand to optimize our financial situation are understanding personal financial basics, how investments work, having a clear vision of our retirement needs, and asset protection. We also need to look at estate planning. And a great place to start is talking about behavioral finance.

Behavioral Finance

Behavioral finance is a relatively new field that combines behavioral, cognitive psychology, conventional economics, and finance to explain why people make irrational financial decisions. Now, that sounds like a mouthful, and I know we said that we weren't going to bore you to death, but in short, it's figuring out why people make bad decisions with their finances. Here are eight cognitive biases that can lead to poor financial outcomes. The first one is loss aversion. So, the psychological and cognitive bias of loss aversion explains the tendency to avoid losses rather than acquire equivalent gains. In other words, people are often more likely to be risk averse when it comes to potential losses than they are to be risk-seeking when it comes to the possibility of gains. The pain of loss is believed to be twice as powerful as the pleasure we get from the gains we get in our investments. This tendency can lead people to abstain from investing in the market simply because they're concerned that their investment may lose some value. Now, this bias can lead to suboptimal decision-making and investing.

Anchoring Bias

Next is anchoring bias. This bias occurs when individuals rely too much on the first information they receive about a particular subject matter. And they use that as an anchor for their decisions moving forward. Now, when we're shopping online, the first price that we see for an item that we're interested in sets an anchor for all the other comparisons after that when we're looking at prices. Salespeople use this to their advantage often. They use this to influence customers to make a purchase. They'll show the customer a higher-priced option for a product or service, which creates an anchor or a perceived value in the customer's mind, then, when the customer is presented with lower-priced options. This exercise tricks a customer into anchoring the value of the first price they saw so that the lower price option appears to be a bargain.

Herding Mentality

Next is the herding mentality or herding behavior. This behavior refers to the tendency of investors to follow the crowd, even when they don't know if it's rational. So, this behavior can lead to group thinking and fear of missing out. So, this can cause market bubbles and crashes. People generally don't want to miss out when there's a perception that everyone else is doing it. If they're following a particular trend, for example, they may think that others know something that they don't, and they don't want to miss out, even if their knowledge on the subject is limited. A good example of this is in the mid-1600s in Holland when there was a phenomenon called the Dutch tulip bulb market bubble. Now, that's a mouthful, but really, what it was is tulip bulbs were considered a symbol of wealth back in the day. It was believed that any man of fortune should have a collection of them. In fact, according to the Library of Economic Liberty, it was deemed a proof of bad taste in any man of fortune to be without a collection of tulips. The perceived value of tulip bulbs was due to the time it took to grow them. Some bulbs were rare and thus had more value attached to them. Everyone believed that the prices of tulip bulbs would only go up, which led people to buy them on credit. And they were hoping they could sell that at a higher price and repay their debt. The problem was that when the price of the tulip bulbs started to drop, people panicked and sold them at any cost. And the result was that people began to go bankrupt.

Mental Accounting

Next is mental accounting. Mental accounting is the inclination of people to interpret and remember information in a way that confirms their pre-existing beliefs and ignores contradictory evidence. Now, that sounds like the average person, right? Let me give you an example. So, for example, an investor may hold on to a particular stock despite clear evidence that it is not performing well. This may be because they have a personal attachment to the company to which the stock is attached. They may have held on to irrelevant information for many years. Maybe it was relevant when they purchased it, but since then, they've lost touch with how that investment is actually doing and how it currently stands. They ignore the facts that don't align with their beliefs.

Risk Aversion Bias

Next is risk aversion bias. This bias refers to people's tendency to choose options with known outcomes or lower perceived risk, even if the riskier option offers a higher expected return. One of the most common instances where we see this bias is when people decide to move everything to cash because they are concerned that the market will take a significant downturn. They neglect the risk of inflation and the additional work they will need to save for retirement in exchange for less potential volatility. Sometimes, people hesitate to take risks because they've experienced adverse outcomes. So, for instance, they might have suffered a significant loss in their portfolio during a market slump. However, it's common for people to overlook that they might currently be invested in something less risky or a less risky allocation than they did during the previous downturn.

Hindsight Bias

Next is hindsight bias. People tend to perceive events as more predictable after they occur. So, for example, an investor may look back at their decision and feel that It's evident in hindsight when it wasn't. So we've all experienced conversations with our significant other where they say, I knew you would say that. I knew that you were going to say X, Y, Z. The truth is they had no idea what we were going to say, but they know us enough to see that as if they had predicted that we were going to say that for the, we're going to take specific actions. Hindsight bias can make us overconfident in our judgment based on available facts. And the problem is that we can oversimplify what's happening in the market. This can lead to dangers when we use this overconfidence to predict the outcome of certain things when we don't have all the information. We may fall prey to hindsight bias and make inaccurate predictions if we perceive patterns that are not there.

Gambler's Fallacy

Next is a gambler's fallacy. This is a bias or belief that future random events are influenced by past events in some way that balances out the previous outcomes, even when there is no logical reason for such an influence. I think the best example of this is when you flip a coin. You could flip a coin and have it land on tails 10 times in a row, and it's easy to think that just because it's landed on tails 10 times in a row, that's gonna influence the next coin flip. In reality, we still have a 50-50 chance of getting heads or tails, even though we have had a run of landing on tails for the last 10 coin flips. Investors can easily fall into this trap by relying on past performance when making investment decisions. So, they may consider an investment's previous winnings or previous losings and see that as an influence on the performance moving forward. And I see this very commonly because

Sometimes, people purchase an investment that has been performing poorly. And they think that because it's been performing poorly over the last couple of market cycles, it will go up at some point and rebound. However, they may be overlooking other factors influencing that investment. Perhaps it's the company that hasn't managed well right now. Possibly, outside factors lead to the price of that investment going down. So, we need to make sure that we consider that bias.

Winner's Curse

Next is the winner's curse. The winner's curse is when an investor pays more for an investment than it's worth. This is usually due to a lack of awareness of the investment's intrinsic value, and the investor ends up outbidding others for that investment. A good example is when investors might be carried away when they're in a bidding war for a property, and they may pay much more than the property is worth. In this situation, all the bidders often assume that their fellow bidders understand the value of the item or property they're bidding for. In reality, each bidder may be increasing their bid because of the influence of the other bidders trying to get that asset.

Conclusion

It's tough to control our internal biases and behavioral tendencies towards ways of thinking about investments, but at least recognizing it is a significant first step. Now, I hope this has been helpful. This is one of many other financial videos that we've put together. And so make sure that you join us next time. In the following video, we'll be talking about financial priorities. So make sure you listen in. Please like, comment, and subscribe if you've gained anything from this. And don't hesitate to reach out to us if you have any questions or need anything. My name is Michael Sayre. I'm with CUI Wealth Management. We'll see you next time.