July 16, 2013

Behavioral Finance and the Impact on your Financial Decisions

Source: When it comes to behavioral finance, there are not many who have a solid grasp of the concept and how it may be impacting their finances. For this reason, we reached out to Dr. Daniel Crosby for some detailed information and advice.

I have claimed to be many things over the years, but a doctor is not one of them. When it comes to behavioral finance, I am the first one to admit this is over my head.

Although I have a basic understanding of what this is all about, when it comes to the finer details I am just as lost as mostly everybody else.

What is Behavioral Finance?

Rather than throw around my own ideas and theories, none of which are backed up by formal education or training, I touched based with Dr. Daniel Crosby. When it comes to behavioral finance, he is the cream of the crop.

You may not know anything about behavioral finance right now, but once you read the following questions and answers you will have a better idea of how this has impacted you in the past and what it means to your future:

1. In “average Joe” terms, what is behavioral finance and how does it impact the everyday person?

Simply put, behavioral finance studies the psychology of investment decision making. Over the last century or so, the stock market has averaged 9 or so percent returns, but the average investor has only made between 4.5 and 7.5 percent, depending on who you ask. So, in many respects we can be our own worst enemy when participating in capital markets. What I try to do is educate investors and advisors to help them overcome this chasm, which has become known as the “behavior gap.” There are hundreds of ways we can get in our own way, a blog I read recently set forth 117 identified biases, but I’ve tried to narrow it down to three S’s to make it a little more manageable.

Simple – There are thousands (millions?) of pieces of economic data available to us so we must use mental shortcuts to simplify the investing process.

Safe – Humans are loss averse, which means we dislike losses more than we like comparable gains.

Sure – We like to have a sense of certainty when making decisions, which can lead us to rely on financial “talking heads” or be overconfident in our own judgment.

All of the three S’s above just “are”, they are only as good or bad as their application. Behavioral finance cut it’s teeth on pointing out how silly and irrational people are, so my goal is to turn those imperfections on their head and see if we can’t use them to investor benefit. I’ve written a three part series on some behavioral finance basics that can be found here.

2. In your opinion, what is the impact on how a child is raised, in financial terms, and how they act financially as an adult?

While I don’t study this in very explicit terms, there is no doubt to me that the financial education a child receives early on has a very lasting impact. Anecdotally, my father is a financial advisor with Morgan Stanley and I know the lessons he taught me as a child absolutely impact my behavior today. “Debt” was every bit as much a four letter word in the house in which I was raised as any of the real four letter words, and those lessons have stuck with me in positive ways.

3. What is your take on whether a better understanding of psychology can lead to a better understanding of the markets?

There are two primary ways in which the lessons of behavioral finance can be applied. First, we can look inside ourselves, determine the ways in which me can make poor decisions with our money and resolve to act in more personally and financially rewarding ways. Second, we can look to the markets and determine ways in which fundamental value has departed from investor sentiment and try to make trades accordingly. I am interested in both applications, but spend the majority of my time in the first camp. When you see how much money is being left on the table by investors, and you consider the good it could do in their lives and the world, it’s easy to get excited about helping people keep their heads when times are tough and to take advantage of what Sir John Templeton called “maximum pessimism.” At the same time, it’s a little sexier to try and trade on psychological market inefficiencies and I’m excited to follow and hopefully be a part of developments in that world as well.

Final Thoughts

If you find this information interesting and want to learn more from Dr. Crosby, check out this video of his session at TEDxHuntsville.

This post is not meant to overwhelm or confuse you. Instead, it is meant to help you better understand behavioral finance and how this could impact your life.

Do you have more questions about behavioral finance or a related topic? Don’t be shy about reaching out to Dr. Crosby on Twitter.

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