Being Human Can Work Against Us
This quarter we will examine the field of behavioral finance. Classical economists believed that people, driven by their self-interest, would naturally behave in a rational manner. Observers of human behavior challenged this belief in many areas and especially with respect to personal finance. By combining the study of finance with human psychology, the field of behavioral finance was born. Most notably, behavioral economists believe that our inherent biases as human beings inhibit our success as investors.
Behavioral finance researchers claim to have identified over 100 biases that stand in the way of our investing success. A non-psychologist might surmise that many of the biases are so similar that they are merely different versions of the same human bias. Just the same, many are significant and improving our awareness can help us overcome them.
Loss aversion is the first behavioral “quirk” we will consider. Classical economics suggests that financial gains and losses should be “symmetric”. This means that the joy we experience from a 10% gain is the same as the dismay we experience from a 10% loss. However, behavioral finance experts have challenged that belief. They cite observed investor behaviors in addition to numerous psychological experiments. Their research indicates that we experience the pain of a loss at twice the rate of happiness we receive from a gain. In other words, we need a 20% gain to neutralize the “hurt” that we encounter from a 10% loss.
Loss aversion can manifest itself in our decisions as investors. We may place inordinate importance on avoiding relatively small losses which can lead us to irrational thinking. One example is an excessive pre-occupation with “getting back to even” on an investment that is in a loss position. We might forsake an investment opportunity with a significant upside, only because we want to avoid realizing a small loss. A rational thinker would admit the mistake on investment #1 and focus on the upside of investment #2. However, our loss aversion bias causes us to insist on sticking with the loser even though we have better opportunities to earn substantially more elsewhere.
If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.