Behavioral finance is a rather interesting science that explains how your emotions and feelings affect decisions and acts connected with finances. It doesn’t sound as serious as inflation, debt consolidation, student loan refinance, or other financial terms, but the behavioral finance definition can clarify a lot of market anomalies and processes.
As you understand, psychology significantly influences not only your personal finances but the whole world economy. And the key aspect is psychological biases. Do you need a bit more to go on? We cooperate with Graham Newell. He is a real expert in behavioral finance research and author of numerous behavioral finance articles. Take a close look at how he explains the basics of this science.
Behavioral finance is the study of crazy ways that is very flawed. Human brains make financial choices. Hi, I’m Graham Newell and I’m a speaker and behavioral finance researcher. I take perverse pleasure in throwing people inside brain scanners. Then I map the parts of their brain that light up as they make tough financial choices. Here’s what I’ve learned.
After many years of peeking inside of people’s brains, most of us believe we make pretty rational financial choices. But nothing could be further from the truth. All of us routinely succumb to the hundreds of cognitive biases that badly distort our money choices.
Roots of Behavioral Finance Theory
Why are people so incredibly bad at money choices? Well, it’s a brain software problem. The human brain has gradually evolved over the past two million years. For 98 percent of that time, our human brain has been chugging along, working hard to optimize for the problems faced by hunter-gatherers, things like not starving in order to avoid freezing to death.
And maybe, if you’re lucky, finding a good-looking cave lady so you can pass along your DNA to the next generation. Fancy skills like agriculture and living in houses are a crazy new lifestyle for humans.
Civilization has been around for only about 10000 years. So although we dress well now and we use all the latest gadgets that are very ancient. Brains haven’t had time to evolve. This means that when we inevitably run into modern problems that are badly out of date, brains still react just like a caveman. This is the reason so many of us get run down and slaughtered when we attempt to navigate modern problems like investing.
Behavioral Finance and Wealth Management
Somehow, next quarter’s earnings projections just never seem to come up around the caveman campfire. Behavioral finance scientists study the very specific ways our brains tend to stumble when making money decisions. And what’s really great about behavioral finance is that a lot of us do our research by playing fun games with people.
So do you think you’re pretty good at managing money? What about behavioral finance examples? Well, let’s play a little game right now. Question for you:
A bat and ball cost a dollar and ten cents. The bat costs one dollar more than the ball. So how much does the ball cost?
Did the answer ten cents immediately spring to mind? And that’s the answer the vast majority of people give. This is an example of a cognitive bias called cognitive reflection.
This test measures our ability to override our incorrect gut response and to engage our wiser, more rational brain. By the way, the correct answer to the question is that the back costs one dollar and five cents, and the ball costs five cents for a total of one dollar and ten cents.
Behavioral Finance Research Basics
Behavioral finance suggests that most of us are really pretty bad at taming our often misguided instinctual brain and behavioral finance research reveals the specific situations when we’re most likely to slip up and make a bad choice.
So what do these biases look like? Well, there are hundreds, but the one that shows up most often in the world of money is the illusory correlation bias. This is our brains’ pesky tendency to believe that a random act is caused by another random act.
For example, I get out of bed every morning and the sun rises too. So I caused the sunrise. And in the past, you’ve just happened to perfectly time an equity purchase and make a fortune. Therefore, you’re a super savvy investor.
Random chance assures that every now and then we’ll all come up winners in the market and our brain has a tendency to remember the profitable trades and forget the losers. And this is how the average investor gets in trouble.
Review of Behavioral Finance: Biases
The most important behavioral finance bias is recency bias, the tendency to overvalue information that we recently read. There’s false memory bias, our habit to recall events that never happened because it fits our narrative.
There’s the availability hubristic, the bias to overthrust facts we can easily pull from memory. There’s the neglect of probability bias, our brain’s tendency to be wildly wrong at estimating risk.
And one of my favorites, survivorship bias, the inclination to overstress the opinions of winners and discount the advice of those who lost.
But if there’s one unanimous conclusion amongst behavioral finance researchers:
The biggest obstacle to wealth is us and the reckless meddling our instinctual brain tempts us to do.
Just take a look at the 100 year history of the Dow and you’ll see it’s pretty easy to make a boatload of money, invest in a diversified portfolio, then leave it alone. Stop looking at it. Stop messing with it.
But we just can’t help ourselves. When markets skyrocket or take a nosedive, our instinctual brain takes over. We’re exuberant. Are we panicking? Our fight or flight instinct takes over and we do stupid things.
Start your behavioral finance education right now. Find a journal of behavioral finance and start studying, check behavioral finance books to know more about how to act in one or another situation. Or at least watch fun YouTube videos that’ll show you how to recognize the signs that an impulsive decision might be likely.
*The primary source of information is Graham’s YouTube video. So, if you are more likely to listen than to read, watch the record below.