Friday, November 25, 2022

What Behavioral Finance Can Teach Us About Investing

By J.P. Morgan Wealth Management

Birds and bees are great – but so are brains. In the last few decades, behavioral finance has emerged as a field of study that merges psychology and finance. It’s a subset within the field of behavioral economics, which was developed by, we assume, super smart dudes named Daniel Kahneman and Amos Tversky.

In 1979, they proposed the idea of prospect theory, which argues that people make decisions based on the potential value of gains and losses rather than the utility of a decision itself. Their empirical findings challenged the assumption that human rationality prevailed in modern economic theory – and in 2002, Kahneman even won the Nobel Memorial Prize in Economic Sciences. (See, we were right, they are super smart.)

To put it simply: investors are humans. We feel greed, fear, hope, excitement – all sorts of emotions impact our behavior on the micro and macro levels. It is precisely because we are human that we often make irrational decisions.

Behavioral finance is what happens when emotions, self-awareness and investing come together. It can help us understand these cognitive biases, as well as strategies for managing them. Here are four of those biases investors may feel:
  • Overconfidence bias: The tendency to see ourselves as more knowledgeable than we actually are. This is common in investing. Overconfidence leads to rash and irrational behavior – like trying to time the market (or eating a really spicy pepper), even though markets are categorically unpredictable, and this has consistently proven to be a losing strategy in the long term.
  • Herd behavior bias: When investors follow others rather than make their own decisions based on financial data (e.g. the Dutch tulip market, or stockpiling a meme stock because all your friends are doing it). People follow herds because it feels safer, or because of the FOMO (fear of missing out) they get from being on the sidelines.
  • Anchoring bias: When an arbitrary benchmark – such as a stock’s purchase price – anchor’s one's decision-making process (“I won’t sell at $X because I bought at $Y!”). With anchoring bias, people tend to hold investments that have lost value because they’re anchoring its value to the price they bought it at, not market fundamentals.
  • Loss aversion: When making decisions, people are more sensitive to losses than they are to gains. Robert Johnson, a professor of finance at Creighton University, argues that loss aversion can cost us money. "The biggest financial mistake people make is taking too little risk, not too much risk," he says. Loss aversion helps explain why: Losses hurt more than gains are enjoyed.
The good news? With just a little bit of strategy and discipline, these biases are easy to overcome. One of the best ways to do this is to put your investing on auto-pilot. In a strategy known as dollar-cost averaging (DCA), an investor puts the same amount of money into the market, at regular intervals, no matter what. For example: $100 on the 15th of every month for a year, automatically, no matter what.

Since DCA is a fixed investment strategy, it neutralizes market performance as a decision factor. This can help you breathe easy instead of constantly making decisions based on anxiety, hunches or best-guesses. Sure, sometimes you might buy a little high. Other times a little low (party time!). But consistency is exactly what diversifies your purchase price – leveling out both losses and your anxiety. For this reason, DCA is an incredibly useful psychological tool for putting investments on auto-pilot.

Often finance and investing is thought of as a pure “numbers play,” but we humans just can’t do anything without putting our heart into things. So understanding why you make decisions, and how to rethink them when necessary, is one of the most important money skills you can learn.

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