Broker Check
You're being irrational! (and so is everyone else) - An introduction to Behavioral Finance

You're being irrational! (and so is everyone else) - An introduction to Behavioral Finance

| October 27, 2021

Ever bought something because you were disappointed or stressed out and needed a boost? Ever sold a stock because it was doing a bit too well and had to be due for a correction? Then you, in practice, experienced Behavioral Finance. Closely intertwined with Behavioral Economics, Behavioral Finance is an area of study that seeks to recognize and understand how humans’ limited rationality, vulnerability to emotion, and unpredictability impact finance. Don’t doubt for a moment that they do—for evidence look no further than cases in which losing sports teams cause stocks to drop due to investors coming into work frustrated and disappointed or the kerfuffle that resulted after investors dumped millions into Nintendo stock following the success of Pokémon Go only to discover that Nintendo didn’t have a major stake in the game, and did not expect it to impact profits.

Traditional economics and finance assume that people are rational, this an important shorthand for researching and understanding the vast arc of economic history, but, when studying more localized matters, such as the decisions of an individual investor, irrationality is an important consideration. We might hope that through trial and error, on a grand scale, humans are rational, but any individual is unlikely to be perfectly rational all the time.

This is more than just academic, the intersection of finance and psychology is critically important to our wellbeing, indeed serious financial losses can be life shortening. Let’s review three phenomena in behavioral finance that can be applied to daily life:

  • The endowment effect: This is a ‘cognitive bias’ that arises when an investor places greater value on an investment they own simply because they own it. Of course, we see it outside of investing as well. If I asked you to estimate the value of your car or home, odds are you would overstate it as compared to the market value. The same is true of investments. Investors overvalue their own portfolios because they are their portfolios. We naturally have a greater affinity for things we possess. To use an investing example, say a client has a typical growth portfolio that is reasonably well constructed and they have held it for some time. Their advisor notes that they could move to a more optimal portfolio, at little to no cost, and have a reasonable expectation of improved performance. A purely rational investor would leap at the chance, but due to the endowment effect, investors tend to be wary of selling securities they possess. They might feel that the current market price of the investments to be sold is too low, or they might feel an entirely irrational attachment to them.
  • Regret aversion bias: This bias occurs when an investor is unwilling to make a decision out of the fear that it will turn out to be the wrong decision, leading to regret. Even though it is irrational, some people would rather sit on the sidelines of the market by staying uninvested, rather than commit to a course of action. This stems from people’s strong desire to avoid experiencing a negative emotion and the greater weight they place on such experiences versus the positive emotion associated with earning a healthy investment return. Hindsight bias also plays a role here, as if markets do fall, those who stayed out will come to believe they made a rational decision to stay in cash, when in fact their decision was irrational and driven by fear and uncertainty.
  • Mental accounting: Economists consider money to be fungible, a dollar is a dollar, regardless of what account it sits in our how it was earned. In practice, however, this is rarely true. The classic example is found money. $100 that you gained by finding a $100 bill on the ground is almost certainly going to be spent much faster than $100 that you earned through work. Mental accounting also arises when people mentally earmark certain sums for certain planned expenses or goals. If you have, say, a vacation fund of $4,000 and then need an emergency home repair costing $2,000, there would logically be no reason, assuming you have no other savings, not to take half the vacation fund and devote it to the home repair. However, many people would charge the home repair instead, as they have a strong mental barrier against ‘raiding’ earmarked pots of money. This is irrational and potentially financially harmful, if, as in the example, you go into debt due to it. Investors practice mental accounting frequently. They are much more likely to take greater risks with investment gains than with principal. An investor with $5,000 of money earned from work in a moderate portfolio will be unlikely to take the $5,000 and invest it aggressively, but if the $5,000 returns $1,000, the investor is far more likely to be willing to hazard that $1,000. If the money is lost the investor might observe: “easy come, easy go” while a loss of principal would provoke a far stronger reaction.

One of the most important roles of a financial advisor is helping clients avoid making rash or irrational decisions due to behavioral factors. As a second set of eyes and springboard for ideas, we can help talk clients through their thoughts and feelings regarding money.