Behavioral Economics is where economics and finance meet psychology and human behavior. I find this area of study very fascinating. As an economics major in college I’ve always been interested in understanding what makes people tick and how we make decisions.
Behavioral Economics has also become more prevalent in the financial advisory industry. This field of study has helped us better understand how human behavior contributes to successful (or unsuccessful) investing.
There are common behavioral biases that impact us as human beings and investors. We are largely driven by our emotions and much less driven by logic.
In fact, Vanguard released a few years ago that found behavioral coaching can add up to 1.5% annually to investor performance. That means if you have a financial advisor who is coaching you to make better financial decisions and to stick with your plan, it can make a big difference in your performance over time. That extra 1.5% per year can add up to significant dollars over time.
Coaching is valuable in any area of your life, so it makes sense that coaching from your financial advisor could make an incremental difference. Unfortunately, not all financial advisors make good coaches.
Financial market and economic cycles could actually be somewhat predictable if it weren’t for humans! We know the order of these cycles, yet we can’t predict the timing or duration. But human beings mess everything up due to the fact that we are emotional beings making irrational decisions much of the time!
The truth is that because of humans impacting the economy and markets, it’s all random. We can’t predict what will happen with any consistent accuracy. That’s why I advocate for having a globally diversified portfolio that is mapped to your personal goals and risk comfort level. When you approach investing in this way, you don’t have to predict and you’re better positioned to capture performance around the globe across many asset classes, sectors, and countries.
Regardless of what we know to be true with Behavioral Economics, misbehavior still happens with investors. There are 5 common mistakes that we make due to these behavioral biases. In this episode, I talk about each one of these in more detail.
The 5 Behavioral Mistakes That Investors Make
As human beings we prefer to avoid losses more than acquiring an equivalent gain. In other words, a loss is much more painful than the gratification we get from again. And so to avoid losses in our lives or anywhere, especially with our money, we might make some irrational decisions to avoid pain.
We as humans tend to believe that we are experts in things that we are not experts in. We tend to overestimate or exaggerate our ability to make the right decisions, and this especially applies to investment decisions. In the episode 30 of the Midlife Money Gal podcast, I talked about how and why women are better investors than men.
One of the reasons for that is as women, we are not over-confident when it comes to making investment decisions and that helps us perform better.
#3)The Herd Mentality
We as humans tend to follow the herd. We tend to jump on the bandwagon when everybody else is saying it and everybody else is doing it. This can cause us to do the wrong thing at the wrong time. If everybody is moving in one direction and thinking in the same way, it is highly likely that something different is actually going to happen!
When we make decisions, we tend to refer to what is familiar to us. The reality is there is probably much more to consider when making decisions, but we can be quick to subconsciously dismiss relevant information or facts that aren’t familiar to our own personal experience. This can lead to less optimal decision-making when it comes to investing.
The value of a dollar is the same no matter what it’s source is and no matter what you do with it. But based on the source or action with our dollars, we place more or less value on our money. This can cause us to overvalue the wrong things and undervalue the right ones! All money is the same.
At the end of this podcast episode, I also share 3 tips for overcoming these investor behavioral biases! Although learning about these common mistakes is helpful, being aware of them in practice is challenging. Awareness can go a long way toward helping you make fewer behavioral mistakes in your financial life.
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