Behavioral Finance Tips

By: David Van Knapp
Classic economic theory posits that investors always behave perfectly rationally, in their own best interests. Emotions are not involved.

You may be thinking, "That contradicts all my common observations and experiences in life," and you would be right. Nevertheless, classical economic theory is based on a world full of rational, informed, iron-willed, self-interested, consistent, and efficient actors.

Behaviorial finance, on the other hand, recognizes the obvious: That investors are often influenced by emotion, and that therefore they make illogical, inconsistent, and ill-informed decisions, despite their best intentions to act in their own self-interest.

There have been lots of studies in behavioral finance since the field took off about 30 years ago. The studies--almost astonishing in their variety--have attempted to find out how most people really act when making financial decisions.

It turns out that we humans have several tendencies that don't help very much when we are investing. They skew our judgment. Here are the most common traits that lead to investor self-sabotage:

--Failing to realize that the loss of an "unbooked" gain really is a loss.

Some investors only think it is a loss if their account falls below what they originally invested. They view an intermediate gain as not real, sort of like playing with house money. Sorry, it was yours, and if you didn't book it, you lost it.

--Failing to book a loss on a hopeless investment, hoping that it will come back. This is called loss aversion--people do not want to admit having made a mistaken investment. Apparently, people feel more pain from a loss than joy at an equivalent gain. They want to avoid regret over the loss, so they just don't book it.

--Failing to take on enough risk, and thus investing too conservatively. Over many years, the most conservative investments (such as cash and bonds) do not keep up with inflation. Thus ironically what seems most conservative actually bears more risk: the loss of purchasing power to inflation as the years pass by.

--Not accepting a loss as the sunk cost it really is. This "sunk cost fallacy" keeps you focused on the past and diverts attention from what you can do now to get better results in the future.

--Selling winners too soon (to lock in profits, thus creating a feeling of victory), but holding losers too long (waiting for them to get back to even so that there is no loss to regret).

--Forgetting that the real goal of investing is to build wealth as effectively as possible, not to justify decisions you've made in the past. This can lead you to fail to evaluate your current investments on their potential to produce gains from this point forward, which at any given time is the important question to ask.

--Becoming paralyzed by too many options. This inability to make "choice under conflict" leads to taking no action at all when action is called for.

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