Behavioral Finance – Don’t Let Emotions Rule Your Thinking!

Behavioral Finance – Don’t Let Emotions Rule Your Thinking!

I’d gotten the better of myself again.

There he was—young, blonde, and single…  And that’s all I knew.  Week after week, he sat in the chapel’s balcony just one pew ahead of me, and yet we never exchanged a word.  I could never find the courage to engage him.  I didn’t want to ruin my first impression and somehow spoil my chance of winning his heart, so I just never had that first impression.

What’s going on here?

What kept me from talking to my crush?  Essentially, it all came down to behavioral psychology.  I was struggling with loss aversion and regret aversion—a couple words you don’t run across every day!  Basically, loss aversion means that the pain of loss is twice as strong as the pleasure of gain.  For me, the thought of a bad encounter with my heart-throb was more emotional than imagining us being happy together.  And, regret aversion meant that I’d rather do nothing than regret my decision.  It felt easier living with the knowledge that I’d never spoken to Mr. Right, than to do so and be flat-out rejected.  Now, don’t judge me—who likes being rejected?

Where else do our biases come into play?

Romance isn’t the only area of our lives threatened by bad thinking.  We all have biases, or ways of thinking, that influence our day-to-day decisions. These biases color everything we do, from choosing where to work, whom to date, and how to invest.  Of course, these biases aren’t all bad.  My fear of car accidents makes me the most vigilant and defensive driver on the road.  However, when our thinking is based on irrational emotions or reasoning that doesn’t quite match reality, we might find ourselves doing things that aren’t in our own best interests.

Our biases also play a huge role in finance.  From the Brexit panic sell to the Trump euphoric rally, investor’s emotions often convulse the market in dramatic swings away from economic fundamentals and toward whatever feels “right” in the moment.  In the end, investors pay for these hasty, emotional choices.  Many frightful investors buy on rallies and sell on dips, exactly the opposite of the old Wall Street adage, “buy low, sell high”.  And the results speak for themselves: over the 20-year period ending on 12/31/13, the “average investor” annualized around 2%, below the 3-month Treasury bill and just above inflation*.  Ouch!!

What can we do about our biases?

What should we do to protect ourselves, from ourselves?  It all starts with knowing yourself.  Discover how and why you make the decisions you do.  Dig deep enough to uncover the hidden motivations, and perhaps sub-par reasoning, behind your choices.  Once we become aware of our own emotional and cognitive “blind spots”, we are taking a powerful first step toward overcoming them.

To that end, one of our top passions at Ibis Capital is providing the financial education you need.  During our State of the Firm event last week, Robert Meyer shared a few of the most common investor biases in his career.  As a follow up, I’m starting a series on behavioral finance.  I’ll cover the four major investor personality types and some tips for offsetting the most common biases associated with each.  Stay tuned!

…And what about my crush?

I know what you’re all thinking—whatever happened with my bashful crush?  After a few months of our silent stalemate on Sunday mornings, he moved out of town for school.  My fear of loss and regret led to actual regret when I lost my one chance of getting to know him.  Talk about ironic!  Learn a lesson from my love life; take control and rule your biases before they rule you!

*Average Investor is represented by Dalbar’s average asset allocation investor return, which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Source: Richard Bernstein Advisors LLC., Dalhar, FRB. Total Returns in USD.

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