Hi everyone, and welcome back to Melissa Making Cents!
As a Certified Financial Planner and Financial Coach, talking about risk is something that I do just about daily with clients and associates. Risk is all around us in the world and marketplace. A few weeks ago, I wrote a blog titledWhat are Risks in Investing?In that blog, I covered various types of risk in investing, like systematic and unsystematic risks. In addition, I talked about how some kinds of risk can be mitigated out of a financial plan while others are built into the overall system of the market. Overall I feel like it was a fairly comprehensive discussion of different types of risk when it comes to finance. However, there are parts of the discussion still left to talk about.
This week we're going to be talking about how behavior and risks are associated in the context of investing. This blog post will also discuss behavioral finance, types of bias, and decision-making errors based on risk and behavior.
Behavioral Finance
For those interested in finance and psychology,Behavioral Finance is an excellent cross-section of the two studies! Behavioral Finance studieswhyinvestors tend to make certain decisions about their investments. It also studies some erroneous cognitive biases that affect decision-making during the investment process. In other words, behavioral finance is the study of why people may ignore reason and "follow their gut"when it comes to investing - even when the numbers, colleagues, or information may point the other direction.
According to Investopedia, Behavioral Finance revolves around five main concepts. These include Mental Accounting, Herd Behavior, Emotional Gap, Anchoring, and Self-Attribution.
The Five Concepts of Behavioral Finance
The first of the five concepts of behavioral finance we'll discuss is mental accounting. Mental Accounting is essentially the tendency to treatsomefunds differently than other funds. For example, imagine that you have a fund set aside for some particular purpose - this could be an anniversary getaway, college fund, vacation savings, or something like that. You also have debt that needs to be paid - however, you don't dip into your special fund to pay that debt even though the debt incurs interest. In this scenario, you're putting different weights on the value of each; this is referred to as mental accounting.
Herd behavior, the second concept, is illustrated in a significant scale any time there's a financial dip. For example, tons of investors rush to sell their holdings at a loss when the stock market dips. However, if they were to hold onto those investments, their price would likely rise again - possibly even higher. This follows the movements of the "herd" and can lead to some negative consequences when investing.
Next, we have Emotional Gap, which is the tendency for investors to make rash decisions that stem from emotion. Emotional gap may be triggered by anger, anxiety, or even good emotions like excitement or encouragement. When investing, acting out of emotion is perhaps the last thing you should do.
Anchoring, our next concept, is another tricky one. It can be sort of challenging to explain but is often also described as benchmarking. This is when people use a pre-set benchmark or anchor to affect their decision-making process with buying or selling. An example of this could be someone saying, "I'm not selling until the selling price is equal to X."
Our last behavioral finance concept is Self-Attribution. Most of us are guilty of this one in one way or another. Self-attribution is essentially the bias that you're going to make the correct choice. An oversimplified way to describe self-attribution is overconfidence in one's self to make the correct decision.
Each of the concepts described carries with it an enormous risk to an investor. These risks pose a self-imposed threat and are pitfalls often fallen into. One way to mitigate these risks is by seeking the outside counsel of a certified financial planner or financial coach.
Types of Bias that Affect Behavior and Risk
Another type of behavior that poses a self-imposed risk to investors are biases. Confirmation bias, experiential bias, loss aversion bias, and familiarity bias are all threats and risks that can affect the overall outcome of an investment.
Confirmation bias is something we've all likely heard about, especially around election seasons. While it's certainly applicable in political tendencies, it's equally relevant in finance. This is starting out with a preconceived notion of what "the right" choice is and working backward from that point. In other words, if I've made up my mind that X is a "bad" investment, any news I hear about it that's negative will work to support my idea no matter if that idea has a realistic basis or not.
Experiential bias is also known as recency or availability bias. This is when you've experienced something - good or bad, and you believe it's highly likely to reoccur. For example, this could happen if you bought X stock right before Christmas and it didn't perform well. This being the case, you're going to avoid purchasing this stock around the holidays.
Loss aversion can be compared to some instances of childhood. Sometimes, when kids learn how to ride a bike, they fall off and don't want to get back on it. Even though they enjoyed riding the bike, they feel that the risk of falling off again is just too great. Applied to investing, this is when you're more worried about losing money than making money. Unfortunately, this leads some investors to be too concerned to take necessary risks to achieve market gains.
Our last bias is familiarity bias. This is a very common bias, especially among those who don't seek the outside help of a financial advisor. With Familiarity bias, investors tend to only want to invest in companies that they're familiar with. This leads to a tiny pool to choose from when investing and often isn't diversified enough.
Risk, Biases, Behavior, and Mitigation
Many of these biases and behavior patterns are based on one thing - risk. So whether it's not being willing to takeanylosses, which stymies the growth of a portfolio, or being so overconfident in your own decision-making abilities that one is acting irrationally, it all comes back to risk.
Perhaps one of the only ways to dissociate ourselves from these risks and biases is to be aware of them. Simply educating ourselves about things like confirmation bias or herd behavior can act as a mental barricade that allows us to step back and think more objectively about the investments and the risks we're taking on. This, mixed with seeking the advice of a certified financial planner or financial coach, is a great way to mitigate some of these behaviors and biases which push us to take on too much or not enough risk.
If you'd like to discuss how to prevent yourself from stepping into one of these pitfalls or just learn more about biases and behavioral finance,please, feel free tocall or email to schedule an appointment with me. Together, we can create a financial plan that eliminates bias and mitigates risk.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.
