“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
– Benjamin Graham
Every investor knows the exact right thing to do with their investing capital all the time – just ask them. These “coulda-woulda-shoulda” stories investors tell themselves are critical aspects of how markets function and why they sometimes behave “irrationally”.
They are so prevalent that there is a psychological field of study which tries to understand these stories – and why our minds work in the way they do to embrace these biases and emotions which so dramatically impact our behavior. It’s called “Behavioral Finance”.
Some concepts which behavioral finance addresses:
- Herd Behavior: people generally tend to mimic what others are doing. This largely explains why we have both dramatic rallies as well as inexplicable sell-offs.
- Emotional Gap: this is an explanation of decision making based on extreme emotions (read: fear and greed) as opposed to data for making investment decisions.
- Self-Attribution: This is the investing equivalent of the fact that 80% of drivers believe they are “better than average”. For investors it means they are generally much more confident than they should be. It leads to the most dangerous of all investors: “those that don’t know what they don’t know”.
These concepts have led to observing tendencies and biases of individual investors. These include:
Confirmation Bias: investors have a bias toward accepting new information which confirms previously held views as opposed to objectively using data to evaluate previous conclusions.
Experimental Bias: If it happened in the recent past its more likely to occur again in an investor’s mind.
Loss Aversion: This is an explanation of the fact investors take greater pain from losses than pleasure from gains. It also explains while investors hold on to losing positions even when they could get a tax benefit from selling – exactly opposite of what objectively is in their best interest.
Familiarity Bias: Investors generally are more comfortable investing in companies that are located close by as opposed to in names of companies they have not heard of. This generally reduces their diversification and increases the volatility of their portfolios.
Why is all this important? Behavioral finance explains why people act irrationally – against data and what is objectively in their best interest. They do this because of how they “feel”. Avoiding letting emotions dictate our investing is exceptionally difficult – even for seasoned professionals. It requires embracing data as the almost exclusive tool to make investing decisions, along with heavy doses of both patience and humility.
As I’ve said to hundreds of families I’ve worked with over the years: “Decisions are best made dispassionately with data over the dinner table”.
If you can make that your investing mantra – congratulations! Otherwise, find yourself an experienced financial advisor who you like and trust who will help you stick to a plan through good and bad times. Your advisor will help you avoid “the stories you tell yourself” damaging your financial future.