- 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 saving their hard-earned capital, so the market’s ups and downs can become emotional. 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 toward expecting growth in the future. This emotional attachment to investments causes concern since it may impact long-term results.
The Role of Behavioral Finance
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 not to 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.
The Impact of Fear/Greed and Bull/Bear Markets
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 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.
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.
The Psychology of Investment Biases
A handful of specific psychological biases are formed when discussing investments. So far, this blog has focused primarily on the concept of Framing Bias. This means that the way the investment is perceived is skewed based on the initial opinion of the investor. 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 investors’ emotional reasons toward losses and how it may vary when applied to gains. The typical investor is more distraught about losing money than ecstatic about earning it. 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, we must ensure our clients’ emotions do not get in the way of their long-term financial goals. This responsibility has become ever 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 the client’s 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 Behavioral Finance, taxes, your individual investment portfolio, our 401(k)-recommendation service, or anything else in general, please call our office 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.
Best Regards,
Zachary A. Bachner, CFP®
with contributions from Robert Wink, Kenneth Wink, and James Wink.
If you found this article helpful, consider reading:
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/