How Behavioral Finance Impacts Personal Investing
Financial planning can be intimidating, but personal financial planning is more like a puzzle you have to work out. That’s because traditional finance assumes that markets are rational and that market participants always make unbiased decisions. Life doesn’t work that way, and neither does financial management.
The reality is that every individual is a confluence of biases, emotions, influences and experiences – and all of those factors impact how we view the world and manage our own money. That’s why some people are risk-takers while others are ultra conservative. So it’s not enough to understand financial markets and products, you must also understand your own emotional processes, mental mistakes and individual personality traits as well as how they affect your decisions.
The factors that influence our financial decisions ultimately create the inefficiencies, anomalies and other inconsistencies that impact the financial markets and the economy. To help you gain insight into how your thoughts and actions affect your finances, consult with a financial advisor to help you understand how your personality traits, demographic and socioeconomic factors, household characteristics, cognitive and emotional biases, political viewpoints, and even religion might affect your financial decisions.
There are a few general steps that an advisor can walk you through to develop a plan to help withstand the force of your own personality from making irrational financial decisions. For example, during peaceful market periods, discuss what individual strategies should be followed when the financial climate becomes volatile.
According to Victor Ricciardi, a behavioral finance and risk expert, the following are five things you should understand about your own investor behavior:
1. Over- and under-confidence are two factors that can lead to portfolio underperformance.
2. Mental accounting is when you focus on the detriment or attributes of a single holding, rather than viewing it within the context of your total, diversified portfolio.
3. Lack of self-control can lead us to spend money on vacations today that we could take when we’re in retirement – with no specific date to return to work.
4. Anchoring bias is when an investor places too much value on the first piece of information that led him to invest in a holding and is unable to accept or process new information as it relates to that holding.
5. Trust and control – when working with a financial advisor, you must exhibit both. Trust his or her judgement but do not relinquish so much control that you place your financial future at risk.
Although behavioral finance is a relatively new concept, experts in the field agree that its tenets go a long way toward explaining why the markets frequently behave in an irrational manner, and how people can impact volatile performance. In other words, it pays to pay attention to how your behavioral biases, emotions and mental processes can affect your own financial decisions. Once you achieve this understanding, you can embark upon some very personal financial planning.