Behavioral finance is an important topic in any discussion about wealth management, as it combines psychology and economics to examine investor decision-making.
Investors often make decisions that run counter to their own best interests and behavioral finance can help us understand why.
There are many instances where irrationality and/or unconscious bias can lead to bad decisions. For example, cognitive bias can limit objective reasoning capabilities since the human brain sends information through a filter composed of experience and preferences. Often, we are unaware of the biases that influence our thinking.
One example of cognitive bias is confirmation bias, which causes us to look for information that is in line with what we already believe. Take the investor who thinks emerging markets are dangerously risky. Believing this, he will seek out information that confirms the perception of high risk, ignoring studies that might suggest such markets outperform over time. Spend an hour on social media and you’ll see that people are willing to believe anything that supports their own point of view. In many cases, a bit of research would debunk these notions but people a) don’t do and research or b) find a spurious reason to discount any introduction of fact.
The Gambler’s Fallacy is another common bias. People tend to believe that if something happens more often than usual during a set period, it will happen less often in the future. Flip a coin and if you get four heads in a row, you’ll start to believe the odds of tails coming up are increasing. But in reality we know it’s 50/50 every time, no matter what the previous outcome.
Negativity bias suggests that anything of a more negative nature has a stronger impact on the brain than things that are positive or neutral. Anchoring happens when you rely too much on the first piece of information you receive. For example, if you toddle into Bergdorf Goodman and see a shirt that sells for $1000, you’ll be prone think the $400 shirt is quite reasonable.
For more on how unconscious biases can thwart your investment goals, please see:
Behavioral Finance: What Everyone Needs to Know | Wealth Management