Behavioral Economics is where economics and finance meet psychology and human behavior. I find this area of study very fascinating. As an economics major in college I’ve always been interested in understanding what makes people tick and how we make decisions.
Behavioral Economics has also become more prevalent in the financial advisory industry. This field of study has helped us better understand how human behavior contributes to successful (or unsuccessful) investing.
There are common behavioral biases that impact us as human beings and investors. We are largely driven by our emotions and much less driven by logic.
In fact, Vanguard released a few years ago that found behavioral coaching can add up to 1.5% annually to investor performance. That means if you have a financial advisor who is coaching you to make better financial decisions and to stick with your plan, it can make a big difference in your performance over time. That extra 1.5% per year can add up to significant dollars over time.
Coaching is valuable in any area of your life, so it makes sense that coaching from your financial advisor could make an incremental difference. Unfortunately, not all financial advisors make good coaches.
Financial market and economic cycles could actually be somewhat predictable if it weren’t for humans! We know the order of these cycles, yet we can’t predict the timing or duration. But human beings mess everything up due to the fact that we are emotional beings making irrational decisions much of the time!
The truth is that because of humans impacting the economy and markets, it’s all random. We can’t predict what will happen with any consistent accuracy. That’s why I advocate for having a globally diversified portfolio that is mapped to your personal goals and risk comfort level. When you approach investing in this way, you don’t have to predict and you’re better positioned to capture performance around the globe across many asset classes, sectors, and countries.
Regardless of what we know to be true with Behavioral Economics, misbehavior still happens with investors. There are 5 common mistakes that we make due to these behavioral biases. In this episode, I talk about each one of these in more detail.
The 5 Behavioral Mistakes That Investors Make
#1) Loss Aversion
As human beings we prefer to avoid losses more than acquiring an equivalent gain. In other words, a loss is much more painful than the gratification we get from again. And so to avoid losses in our lives or anywhere, especially with our money, we might make some irrational decisions to avoid pain.
We as humans tend to believe that we are experts in things that we are not experts in. We tend to overestimate or exaggerate our ability to make the right decisions, and this especially applies to investment decisions. In the episode 30 of the Midlife Money Gal podcast, I talked about how and why women are better investors than men.
One of the reasons for that is as women, we are not over-confident when it comes to making investment decisions and that helps us perform better.
#3) The Herd Mentality
We as humans tend to follow the herd. We tend to jump on the bandwagon when everybody else is saying it and everybody else is doing it. This can cause us to do the wrong thing at the wrong time. If everybody is moving in one direction and thinking in the same way, it is highly likely that something different is actually going to happen!
When we make decisions, we tend to refer to what is familiar to us. The reality is there is probably much more to consider when making decisions, but we can be quick to subconsciously dismiss relevant information or facts that aren’t familiar to our own personal experience. This can lead to less optimal decision-making when it comes to investing.
#5) Mental Accounting
The value of a dollar is the same no matter what it’s source is and no matter what you do with it. But based on the source or action with our dollars, we place more or less value on our money. This can cause us to overvalue the wrong things and undervalue the right ones! All money is the same.
At the end of this podcast episode, I also share 3 tips for overcoming these investor behavioral biases! Although learning about these common mistakes is helpful, being aware of them in practice is challenging. Awareness can go a long way toward helping you make fewer behavioral mistakes in your financial life.
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(00:06): Welcome to the midlife money Gow podcast. This is the show for independent women professionals who want to learn more about navigating mid life and money. I'm your host, Stephanie Sammons, an experienced certified financial planner and Midlifer just like you behavioral economics. It's a new one, newer
(00:31): field of study out there where economics and finance meet psychology and human behavior. And I find this area of study very fascinating. I could read about it and study it all day long. As a financial advisor. Behavioral Economics has become more and more prevalent in our community because it has helped us understand that human behavior is a big contributor to how our clients do over time with sticking to their financial goals, with sticking to their investment strategy. And we've actually learned and uncovered what the common behavioral biases are that impact us as human beings. We are largely driven by our emotions and much less driven by logic. And the more emotional that we get about something, the more likely we are going to make an emotional decision and not be able to step back and think about it logically. So I love behavioral economics. Uh, I was an economics major in college and I've, I've always been really fascinated by what makes people tick, what makes people do what they do, even when you know better what to do, but you can't make yourself do it.
(02:08): I just think that is really, really interesting. Vanguard released a study awhile back few years ago that found that behavioral coaching can add up to one and a half percent annually to investor performance. And that means if you have a financial advisor who is coaching you to make better decisions and to stick with your plan, that that can make a big difference in your performance over time. One and a half percent per year adds up to a lot of dollars over a longer period of time. So this stuff is real and we see it every day in working with clients as financial markets and economic cycles would really be somewhat predictable. You know, we know the order of these cycles. We know what comes first and what follows. We don't know the timing. We don't know how long each phase of a market or economic cycle will last. But human beings mess all of that up and because we are emotional beings and we make emotional decisions that are unique to our personal situations, all of these humans acting emotionally really mess up the ability to predict anything and that's why you often hear, don't try to time the stock market, don't try to figure out when to get in and when to get out.
(03:50): Don't try to predict whether or not we're going to have a recession or we're not going to have a recession because the truth is that it's all random and it's random because human beings make it random. We mess it up because of our behavioral biases that are just inherent to us because this is all random. That's why you often hear financial planners and financial advisors talking about having a globally diversified portfolio that is mapped to your unique goals and needs. The truth is when you approach investing in that way, you're better positioned to capture performance across the world in all the different asset classes and sectors and countries. Rather than trying to predict what's going to do well tomorrow, next week, next month, next year. We can't predict this stuff, so it's better to take a diversified approach when it comes to your investments and you probably already know that.
(05:12): I want to talk about these behavioral biases that we have because they do impact decision making and the more aware you are of these common biases and that these common ways that you might react and behave the more you might be able to stop yourself and count to 10 and think about it before you make an irrational decision. So I'm a big fan of making you aware and educating you so that you know about these things ahead of time with regard to your financial life. Now in good economic times, when things are well and the economy's in good shape and everybody is spending and feeling pretty good, it's much easier to be a more successful investor. However, when the economy becomes more volatile, the stock market becomes more volatile. That's when it becomes much more difficult to make better decisions with your money and that's what I want you to be prepared for and have a plan for and understand your behavior.
(06:32): When more volatile times start to happen. All right, so let's talk about these five common investor mistakes that can cause bad behavior. Number one is loss aversion. As human beings we prefer to avoid losses more than acquiring an equivalent gain. In other words, a loss is much more painful than the gratification we get from again. And so to avoid losses in our lives or anywhere, especially with our money, we might make some irrational decisions because it is so painful. It's more painful than missing out on the upside loss aversion. That's the number one investor bias. Number two is overconfidence. We as humans tend to believe that we are experts in things that we are not experts in. So we tend to overestimate or exaggerate our ability to make the right decisions. And this especially applies to investment decisions. In the last episode, episode 20 I talked about how women were better investors than men.
(08:02): And one reason for that was because we are not over confident when it comes to making investment decisions as women. And that tends to help us perform better over confidence can get you into trouble and it can cause you to do the wrong thing at the wrong time. The number three behavioral investor mistake or investor bias is called hurting and I think of a herd of cattle. When I think about hurting, you know how cattle kind of all moved together in the same direction. We as humans do the same thing. We tend to mimic the actions of the larger group and that can cause us to be very impulsive with our decision making. If for example, you hear about your best friend who is touting a particular stock that they are interested in or that they have purchased and they're telling you that, oh, it's doing great, it's going to go to the moon and you run home and you buy it for yourself, you may be making a big mistake.
(09:18): We tend to jump on the bandwagon when everybody else is saying it and everybody else is doing it and you want to be somebody who thinks about what's the opposite of the herd mentality. This kind of contrarian view. If everybody is moving in one direction there everyone is thinking in the same way then something different is actually going to happen so be aware of that. When you hear people saying the same things in predictions, it's probably the opposite that's going to happen. The number four investor bias is familiarity. That's kind of a hard word to say. Familiarity. As humans we tend to prefer what is familiar to us or what is well known to us and then we'd go out and we make decisions based on what we think because it's been a part of our past experience or it's something that's in our everyday lives and we're just so familiar with it and that can cause you to make mistakes and make the wrong decisions.
(10:38): The reality is there is probably a lot of information that you don't have or facts that you are missing or something that you don't know because it's not familiar to you that can cause problems when it comes to your money. The number five investor bias is mental accounting and mental accounting is where you attach different values to money based on its source or use and that can cause a rational decision making. For example, let's say that you'd go to a baseball game and at the baseball game you've rationalized in your mind you're willing to spend $8 on a beer to watch the baseball game and that is worth it and it's the cost is, is not, doesn't bother you because you're at the baseball game. However, then you go to the grocery store and they want $8 for the same beer when the reality is you could probably buy six of those beers, a six for the same price.
(11:55): Then you get frustrated by that and you think that's way too expensive. This is how we mentally account for our money. We put different values on our dollars based on what we're using it for and that can lead to problems. All money is actually the same. Every dollar that you have and that you spend or save is the same. It has the same value. So try to think about how you are thinking about your dollars. Okay, so now let me give you three easy solutions for better investor behavior. I think that these three tips can help you be more disciplined when it comes to your money, your portfolio, or your financial life. Number one is remove the negative triggers. Things like the news, the media, online articles, magazines, the things that that play on your emotions with fear and greed and that talk about the markets and the economy and political turmoil and all this stuff.
(13:12): Those are all triggers and it festers in your mind and it starts to impact your behavior over time. If you continue to expose yourself to those types of triggers, they will influence you to make potentially the wrong decisions at the wrong time. Number two, don't look at your accounts, your investment accounts. Don't look at them every day, every week, every month. Even you're putting yourself on an emotional roller coaster for no reason at all. You are borrowing worry. Investor performance is really not relevant unless you're looking across longer periods of time. Otherwise you're just going to be riding that roller coaster and stressing yourself out for no good reason. Stop looking at it every day, every week, every month. It's just not worth it. There's nothing productive that will come from that. And number three, review your financial plan and your investment portfolio with your advisor, your financial planner or financial advisors should be your accountability partner in terms of keeping your emotions in check. Are you on track? Do you have enough of a cash reserve in case there is an extended downturn in the economy and in the stock market? Do you have enough time to let the ups and downs play out without having to tap into your nest egg?
(15:00): what is your current downside potential with the portfolio you have today? These are all kinds of things that you want to talk through your financial advisor with cause you only want to take as much risk as necessary to be able to stay on track toward achieving your financial goals. So my three solutions to overcoming bad investor behavior that we're all subject to if we're not careful and we're not aware, are removing outside triggers that are negative, not looking at your accounts daily, weekly, monthly, and number three, reviewing your financial plan, your investment strategy with your financial advisor or financial planner. Now that you're more aware, you're going to be better equipped to recognize
(15:59): and overcome financially counterproductive biases that can hurt you. Over top, you've been listening to the midlife money Gow podcast. You can follow me on Instagram at Stephanie Sammons and Facebook at Stephanie Sammons, CFP, or visit midlife money, gow.com if you haven't yet, go to apple podcast and subscribe rate and review this podcast. Join me next week for another episode on navigating Midlife and money. Thanks for listening. The information on this podcast is for educational purposes only and should not be considered specific investment, tax, or legal advice. Please consult with your own professionals who have complete understanding your situation.
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