Plan for Success

Terry Hartigan | Principal

Developing a road map to achieve financial success.

Understanding Behavioral Finance Can Give You the Edge

June 2017

Key Takeaways:


• Behavioral finance uses theoretical and empirical academic research to explain why investors often do not act rationally.
• Understanding both the “how” and the “why” of irrational behavior can be invaluable to investors.
• Research shows that many individuals are overconfident, under-diversified, short-sighted and easily swayed by the media.
• Learn how to protect yourself from your basic instincts.

If the world were full of “rational” individuals who could maximize their wealth while minimizing risk, there would be no need for wealth advisors. Rational individuals would assess their risk tolerance and then determine an investment portfolio that met their ideal level of risk aversion. However, we know that most individuals are not capable of being rational. Most successful people don’t want to think that they are incapable of being rational about their wealth, but it is important to point out why your financial advisors plays an important role in reminding you how to be “smart” about your wealth.

Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain why people, especially investors, do not act in a rational manner. Think of the moniker “behavioral” as describing how and why individuals behave the way they do.

First let’s look at the “how.” Here are some findings, based on empirical research, that explain how investors tend to behave when they don’t have expert guidance to help them:
• They invest in under-diversified portfolios.
• They trade actively with high turnover and high transaction costs, which have a significant drag on their returns.
• They are influenced by where they work and live. They invest heavily in the stock of their employers, and they tend to invest in stock of companies based in their home country, and even companies located near where they live.
• They are often influenced by companies that get lots of media attention. They tend to buy, rather than sell, companies that are mentioned positively in the news.
• They tend to sell their winning investments while holding on to their losing investments way too long in the inevitable chase to “break even.”
• Men tend to trade more often than women do. Men’s excessive trading leads to lower returns relative to women’s.

Now let’s look at why individuals behave a certain way, which is based on theoretical research. Here are some theories:
• Psychology research supports the theory that individuals are generally overconfident. The overconfidence of individuals explains why they trade actively and have under-diversified portfolios.
• Psychology research supports the theory that individuals believe they are better than the average individual, which makes them overconfident.
• Psychology research supports the theory that investing in stocks is a sensation-seeking activity for many individuals. It’s a form of entertainment and gives many individuals an adrenaline rush that’s akin to what drives people to gambling.

Conclusion
Behavioral finance literature serves as a reminder why it so important to protect yourself from you basic instincts—especially when markets are volatile. Safeguarding your wealth is responsibility, not just to yourself, but to your family and the causes you support. To many individuals, the appropriate stewardship of their wealth is a responsibility to one’s self, as well as to one’s family, house of worship, community organization and country. Never be afraid to ask us for help or suggestions if you suspect you might be drifting from your plan.

Article courtesy of CEG Worldwide, LLC, 2017 www.cegworldwide.com | info@cegworldwide.com

 

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