By Cheryl Harwell
Behavioral finance is becoming a much more popular discipline in the field of financial planning and investments.
What is behavioral finance, you may ask? It is the study of the influence of psychology on our behavior as investors. The underlying focus is that investors do not always make rational decisions. Our behaviors around investing, as in many other areas of our lives, are affected by our cognitive biases, behavioral habits, and ability to maintain self-control, among other psychological tendencies.
Behavioral finance identifies some of the common biases that investors encounter. As behavioral finance blends psychology with investment behaviors, it makes sense that we confront the same biases in investing as in other areas of our lives. The idea is to understand how these biases potentially affect investment behavior so we can help clients avoid the pitfalls they tend to engender.
Common biases that affect investor behavior:
Loss aversion is a tendency in investors to be so fearful of losses that they focus on trying to avoid them rather than on growth or gains. The more clients experience losses, the more likely they are to become prone to loss aversion.
Overconfidence is the tendency for clients to hold a false and misleading assessment of their own skills, intellect, or talent. In short, it’s an egotistical belief that we are better than we truly are. Investing involves risk, and over time, taking risks can lead to gains. Of course, losses may be sustained along the way, as well. Historically, long-term investors have reaped rewards. When clients make investment decisions that result in gains, this experience can lead to overconfidence in future decision-making. Overconfidence can also lead to several other types of biases, including an illusion of control, accurate market timing, and the desirability effect.
Herd mentality refers to investors’ tendency to follow and copy what other investors are doing. They are largely influenced by emotion and instinct rather than by independent analysis. The idea that social influences and other investor decisions impact their own, regardless of any fundamental or logical decision-making, is an example of herd mentality. It has become even more prominent for investors in today’s world due to the immediate access of information through social media and financial / market news platforms.
The bottom line is that understanding the basic principles of behavioral finance as it relates to financial planning can help advisors assist clients to be more financially successful long-term. Maintaining focus on things that we can control, such as developing a diversified asset allocation based upon goals and risk tolerance, automating contributions to investment accounts, rebalancing annually, and keeping costs low, are crucial. Also important is avoiding what we are not able to control, such as how the markets will perform daily and accepting the fact that we cannot accurately time the market. Having a process in place helps to mitigate the outside influences presented to clients and will help advisors assist them in reaching their goals.
Consider learning more about behavioral finance to benefit your investment processes and your client relationships! If you have any questions, please contact me in Case Planning (email@example.com).
We DELIVER great service to independent representatives! To learn more, contact Kristi Delongchamp at (888) 744-6264 or firstname.lastname@example.org.
About SPS Family
The SPS Family consists of two broker-dealers, Sigma Financial Corporation and Parkland Securities, LLC; a Registered Investment Advisory firm, Sigma Planning Corporation; and a back office, known as BD Ops, LLC. The companies, based in Ann Arbor, Michigan, are under common ownership and led by an experienced executive team. The SPS Family prides itself on personal service to independent registered representatives and investment adviser representatives from across the United States. We consider our representatives family as we strive every day to provide them “Independence. DELIVERED.”
300 Parkland Plaza | Ann Arbor, MI 48103 | 888-744-6264