What Is Behavioral Finance?
- Behavioral Finance is the textbook term used when discussing human psychology as it relates to money management.
- Emotions tend to drive the investment decisions of retail investors while large financial institutions rely on technical and fundamental analysis.
- One of the most important job duties of a financial advisor is to play the role of “therapist” when client emotions reach either the fear or greed extremes.
The Emotional Connection to Finances
Understandably so, investors will tend to become emotionally connected to their finances over time. Individuals and families spend their lives savings their hard-earned capital, so the ups and downs in the markets can become emotional times.
This is further amplified when the investor is personally selecting the investments since they may have a pre-existing bias. Many retail investors pick and choose their investments based on the companies they personally use and have an existing personal connection to.
This creates a potential conflict of interest since they are biased towards expecting growth in the future. This emotional attachment to investments causes concern since it may impact long-term results.
Difference Between Retail Investors and Institutions
Behavioral Finance claims that investors, especially inexperienced investors, may make financial decisions based on emotion rather than more traditional methods.
Large financial institutions and money managers tend to use Fundamental and Technical Analysis when deciding which investments to pursue.
For further information about these styles, we invite you to check out our previous blog post dedicated to the topic of Fundamental Analysis.
As a result, behavioral finance is focused more heavily on retail investors since they tend to not have the resources available to perform in-depth analysis, or perhaps they believe their emotions are a strong enough financial compass to direct their investment decisions.
Fear, Greed, and Market Cycles
This concept amplifies the Fear/Greed conversation and the Bull/Bear discussion we have had in the past blog entries.
Retail investors tend to chase market returns when things are going great and they tend to sell their investments after already incurring losses. Professional money managers tend to trade against the flow of retail traders and often the best time to buy an investment is when there is the most fear in the market.
More retail investors struggle to counter their emotions and to follow this strategy. Also, this emotional connection is typically what causes Bull and Bear markets to exist since more investors are willing to buy in good times and more willing to sell in bad times.
How Herd Mentality Affects Market Behavior
This can cause the market cycles to extend longer than perhaps originally anticipated since the emotional response to the initial move is amplifying it.
This concept is referred to as “Herd Mentality” and explains why some investors tend to use recent market performance to dictate their next decision.
Common Psychological Biases in Investing
There are a handful of specific psychological biases that are formed when discussing investments. So far, this blog has focused primarily on the concept of Framing Bias, which means that the way the investment is perceived is skewed based on the investor’s initial opinion.
The investment is framed in a specific way, and it can become hard to change that point of view. Another major concept we want to address is Loss Aversion. This refers to the emotional reasons investors have toward losses and how they may vary when applied to gains.
The typical investor is more distraught about losing money than they are ecstatic about earning money. Simply put, some investors are so concerned about losing money that they refuse to partake in various investment opportunities despite the potential positive outcome.
The Role of Financial Advisors
As financial advisors, it is our job to ensure our clients’ emotions do not get in the way of their long-term financial goals. This responsibility was more prominent during the volatile year of 2022.
Stocks and Bonds struggled throughout the year so even our low risk clients were beginning to feel uneasy about investing in general. At times, a financial advisor plays the role of “therapist” in an attempt to understand and rationalize client emotions.
Yes, we must follow client instructions and their requests, but we often feel the need to provide our input. “Herd Mentality” is what typically causes investors to buy their positions at the highs and sell them at the lows.
We believe it is our duty to ensure our clients fully understand the potential repercussions of their decisions, especially if we believe they are following their emotions rather than for a statistical or analytical reason.
Speak With a Trusted Advisor
If you have any questions about your investment portfolio, retirement planning, tax strategies, our 401(k) recommendation service, or other general questions, please give our office a call at (586) 226-2100.
Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or your overall financial situation, please give us a call so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them.
Sincerely,
Zachary A. Bachner, CFP®
with contributions from Robert Wink, Kenneth Wink, James Wink, and James Baldwin
If you found this article helpful, consider reading:
- How Do Bull Markets and Bear Markets Differ
- Navigating College Funding
- Financial Planning Mistakes to Avoid
Sources:
- https://www.investopedia.com/articles/02/112502.asp
- https://www.kaplanfinancial.com/resources/career-advancement/behavioral-finance
- https://www.businessinsider.com/personal-finance/what-is-behavioral-finance
- https://summitfc.net/fundamental-analysis/
- https://summitfc.net/fearvsgreedindex/
- https://summitfc.net/bull-vs-bear-market/