Many of you may not have heard of the term behavioral finance, but it is hard to find a point where our minds do not get in the way of our money. It happens all the time. We try to kid ourselves that we are rational human beings who make rational decisions, but history and our stock market has proved us wrong time and time again.
In fact, we let our emotions take hold of us more often than we would like to admit much to the detriment of our finances. Below are three classic examples of behavioral finance and how we behave irrationally with our money and let our minds get in the way and cost us.
We Have an Aversion to Losses Because of Behavioral Finance
When we are investing for our financial goals, whether it is buying a home, retiring early, sending our children to college, or any one of the hundred others, a rational person is supposed to step back and look at the big picture. You are supposed to consider your total investment portfolio, and the goal is to increase your wealth to accomplish these financial goals.
But, far too often, we look at the individual wins and losses. I’m sure that most of the readers can quickly name a stock or mutual fund that has cost them a significant loss over their investing career. Investors have a loss aversion, and we tend to focus on our losses as opposed to the other investments that are in the black.
We would rather avoid a loss altogether than risk it for a chance at gains. Investors often sell winning stock in order to lock in a profit and hold losing stocks as they sink further and further in an effort not to have to actually accept the current loss on paper.
How To Avoid Risk Aversion In Your Life And Investments
If you had the choice of keeping your current job at your current salary or taking a chance on a new venture that has a 50% chance to either double your income or 50% chance of reducing your income by 25% which would you choose?
Let me frame it a slightly different way. Let’s say that you currently make $50,000 at your day job. You could keep working 9-5 and do nothing. Or, you could take a chance with a new venture that has the possibility to either double your income to $100,000 or reduce your income to $37,500. Which would you choose? If you said that you would just stay where you are with your current job and not risk it, you are not alone.
What Is Risk Aversion?
Risk aversion is a phenomenon where a person or an investor is reluctant to accept a loss when there is the possibility to receive a loss. It comes down to what a person perceives as the gain and also the loss. Studies have shown that most people cannot stomach losses.They would rather give up the possibility of gains in order to ensure that they do not suffer a possible loss even if the risk of a loss is less than the chance of the gain.
They would rather give up the possibility of gains in order to ensure that they do not suffer a possible loss even if the risk of a loss is less than the chance of the gain.
So, how do you avoid risk aversion? The best way to avoid risk aversion is to understand expected value. In statistics and probability theory, the expected value is the weighted values of all possible outcomes. So, for example, if a stock valued at $100 per share has a 50% chance of rising to $150 during the course of a year and a 50% chance of dropping in value to $80, then it has an expected value of $115 ($150 x 50% + $80 x 50%) by the end of the year.
So how do we put it all together and what does it all mean to the average person. The one surefire way to have half a chance to avoid risk aversion is to understand it. It is everyone’s natural inclination to want to avoid losses.
No investor wants to lose money, but it is important to understand that many of our fears are not founded in science and actuality. Often the fear of suffering a loss, even a small loss, keeps us from potentially earning significantly more money with other opportunities.
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We Are Overconfident in the Things We Know
Are you a good driver? Progressive Insurance conducted a simple study where they asked a random sample of Americans if they were a good driver. Over 93% felt that they were better than average. This statement alone is impossible. The law of large numbers and a standard distribution of people’s driving skills show that it is extremely unlikely for more than 50% of people to be better than the average.
Are you a good investor? There is a direct correlation between overconfident drivers and overconfident investors. In fact, the correlation is just overconfidence. We are guilty of it with our money just like driving. Those of us who handle our own investments, buy individual stocks and skip the advice of a financial planner think that we can do it better than ourselves.
We Are Biased on What We Know
How do you choose which stocks and mutual funds to purchase shares of? I can rattle off an entire list of stocks that I have invested in over the years, and many of the products those companies make are sitting on my desk and around my office. While Warren Buffett correctly recommends investing in companies that we understand, many of us tend to go one step further and invest in the handful of companies that we know that best. It is a form of availability bias.
We are biased on what we know without having to learn something new. Instead of finding the diamond in the rough stock to invest in that has the possibility to potentially earn more than the average market return, we stick to the few stocks that we know who may or may not have a track record of keeping up with the overall stock market simply because their history and stories are familiar to us and available.
Can we get over our mental roadblocks with respect to how we deal with our money? Maybe we can and maybe we cannot get over the hurdles. But, understanding that those hurdles are present can make us a more effective investor. Like G.I Joe always said, “Knowing is half the battle.” Now, you know that you do not act rationally. What you choose to do with that knowledge is up to you.
Have you ever thought about starting your own business but were scared about the potential downside? Did you ever balk at a new investment idea or stock that you had a great feeling about? Loss aversion can keep us from earning more in our lives. It is through understanding the human psyche and yourself that can help you avoid risk aversion in your life and investments.
What about you? Has there ever been an investment that you balked on out of fear of a loss?