Introduction to Behavioral Finance

Presented by: Michael Sayre, CPFA™, AIF®

Transcript

The average American spends about one-third of their life working. That is a lot of time spent working. With so much of our lives dedicated to earning money, it's essential to understand how to make the most of our money. In other words, you work hard for your money, so make sure your money works for you and avoid those things that erode our wealth.

My name is Michael Sayre, and I am an advisor with CUI Wealth Management. Let's talk about some of the fundamental concepts of finance.

This is one of many videos we've created to discuss finance principles. We'll cover some basics to help you make better decisions, but don't worry—we won't bore you with numbers or make you feel guilty about your coffee habit. We might do that a little bit. However, we aim to focus on how small changes can produce significant results.

Personal finance is about making smarter choices with your money—choices that provide you with more freedom, less stress, and the ability to enjoy the things you love without constantly worrying about your next bill.

Concepts like budgeting might sound about as exciting as watching paint dry, but hear me out. Without a solid grasp of financial fundamentals, you're essentially flying blind. While you might be getting by, you could be doing much more with your money if you had a clear picture of where it's going.

Some foundational concepts we need to understand to optimize our finances include personal finance basics, how investments work, a clear vision of our retirement needs, asset protection, and estate planning.

Behavioral finance is a relatively new field that combines behavioral and cognitive psychological theory with conventional economics and finance to explain why people make irrational financial decisions. In short, it asks what behaviors lead us to make poor financial decisions.

Here are eight cognitive biases that can lead to poor financial outcomes.

Loss Aversion Bias

This psychological and cognitive bias explains the tendency to avoid losses over acquiring equivalent gains. In other words, people are more likely to be risk-averse when it comes to potential losses than they are to be risk-seeking when it comes to possible gains.

The pain of loss is believed to be twice as powerful as the pleasure we get from gains. This tendency can lead people to abstain from investing in the market simply because they are concerned that their investments may lose value. This bias can lead to suboptimal decision-making in investing.

Anchoring Bias

This bias occurs when individuals rely too much on the first information encountered when making decisions. When shopping online, the first price you see can set an anchor for comparison with subsequent prices.

Salespeople often use a technique to influence customers to make a purchase. They show customers high-priced options for a product or service, which creates a perceived value in the customer's mind. Then, they present the customer with lower-priced options. This exercise tricks the customer into anchoring the value to the first price they saw, so the lower-priced options appear as a bargain.

Herding Behavior

This behavior refers to investors' tendency to follow the crowd, even when it may not be rational. This behavior can lead to groupthink and the fear of missing out, which can cause market bubbles and crashes.

People generally don't want to miss out when they perceive that everyone is following a particular trend. They may think others know something they don't, and they don't want to miss out, even if their knowledge of the subject is limited.

During the mid-1600s in Holland, there was a phenomenon called the Dutch Tulip bulb market bubble. Tulip bulbs were considered a symbol of wealth, and it was believed that any man of fortune should own a collection of them. In fact, according to The Library of Economics and Liberty, "it was deemed a proof of bad taste in any man of fortune to be without a collection of [tulips]." (Goldgar, 2008)

The perceived value of Tulip bulbs was due to the time it took to grow them, and some bulbs were rarer and thus more valuable than others. Everyone believed that the price of Tulip bulbs would only go up, which led to people buying them on credit with the hope of selling them later at a higher price to repay their debt. However, when Tulip bulbs started dropping, people panicked and sold them at any cost. This resulted in many people going bankrupt.

Mental Accounting

Mental accounting is the inclination to interpret and remember information in a way that confirms one's preexisting beliefs while ignoring contradictory evidence.

For example, an investor may hold onto a particular stock despite clear evidence that it is not performing well because they have a personal attachment to the company. They may have held on to relevant information from many years ago, but they have lost touch with the reality of the investment as it currently stands. They ignore the facts that don't align with their beliefs.

Risk Aversion Bias

This bias refers to people's tendency to choose options with known outcomes or lower perceived risk, even if riskier options offer higher expected returns.

One of the most common instances of this bias is when people decide to move everything to cash because they fear market downturns. They neglect the risk of inflation and the additional work needed to save their funds for retirement in exchange for less potential volatility.

Sometimes, people become hesitant to take risks after experiencing a negative outcome. For instance, they might have suffered a significant loss in their portfolio during a market slump. However, it is common for people to overlook the fact that they might currently be invested in a less risky asset allocation than they were during the previous downturn.

Hindsight Bias

People tend to perceive events as more predictable after they occur. For example, an investor may look back on their decision and feel it is evident in hindsight when it was not.

We all have experienced conversations with our significant others where they say, "I knew you were going to say that." The truth is that it's easy to know enough about someone not to be surprised by their actions in certain situations.

However, hindsight bias can make us overconfident in our judgments based on the available facts. The problem with this is that we oversimplify what is going on. This can be dangerous when we use this overconfidence in predicting the outcome of an investment. We may fall prey to hindsight bias and make inaccurate predictions if we perceive patterns that may not be there.

The Gambler's Fallacy

This bias is the belief that future random events are influenced by past events in a way that balances previous outcomes, even when there is no logical reason for such an influence.

For example, a person may believe that a coin is more likely to land on heads if it has landed on tails several times in a row when each coin flip is independent of the previous one.

Investors can easily fall into the trap of relying on past performance when making investment decisions. They may consider an investment's previous winning or losing streak to indicate its future performance.

For instance, they may purchase an investment that has been performing poorly for the last few market cycles, hoping it will rebound and become profitable again; however, when they overlook other factors that could impact the investment's value, such as changes in the market or the company's financial health. In that case, they may be setting themselves up for failure.

The Winner's Curse

The Winner's curse is when an investor pays more for an investment than it is worth. This usually happens due to a lack of awareness of the investment's intrinsic value, and the investor ends up outbidding others.

For instance, an investor might get carried away in a bidding war for a property and pay much more than the property's actual value. This situation often arises when all the bidders assume that their fellow bidders understand the value of the item or property they are bidding for. In reality, each bidder may be increasing their bid because of the influence of the other bidders.

By understanding these biases and tendencies, investors can become more aware of their decision-making processes and make more rational financial decisions. Overcoming these biases is difficult, but knowing them is an essential first step.

In conclusion, behavioral finance is an important field that can help investors better understand their decision-making processes and make more rational financial decisions. By recognizing the various biases and tendencies affecting financial decision-making, investors can become more informed and make better decisions in the long run.

We will discuss financial priorities in the next video. Make sure you listen in. Our contact information is below if you have any questions or need assistance.