Level 5 Financial Blog
Anyone who has studied a document which illustrates the financial returns of a particular investment is most likely familiar with these words. The regulatory bodies require this disclaimer to be included with any reporting of investment results. While the regulators seek to prevent unscrupulous sales personnel from overpromising results, these words also sum up our next behavioral finance bias. Recency bias has caused many an investor to be disappointed with their selection of a particular security.
One common bias that investors must overcome is known as confirmation bias. It comes into play after we have researched and analyzed a potential investment and made a decision regarding its relative merit. If our impression is that the investment is worthy of purchase and do so, confirmation bias will cause us to only seek out additional information about the investment that confirms our initial positive opinion. Likewise, we will ignore or downplay any new information that contradicts our initial impression. Confirmation bias also works against us when our first research conclusion is negative. If we initially decide not to make a purchase, we will continue to seek out only information that reinforces the original negative assessment.
Behavioral finance researchers have noted that many of our financial decisions are based on “reference points”. Numerous experiments have been conducted which validate the concept that we make decisions based on a previously identified number. For instance, we may have difficulty deciding if $100 is a fair price for an item #1 if we are initially given no other information. However, if we are shown a similar item and told that its price is $200, we become much more likely to state that the $100 item is fairly priced. This belief occurs even though we have received no additional information about item #1. Surprisingly, this is true even when people know the initial item’s $100 price was merely a random amount.
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.
As our quarter’s focus on taxes comes to a close, we will step back from the details and examine our overall system of taxation. Some Americans believe the only sound tax policy is the policy that minimizes taxes. However, most of these same people would be appalled at the devastation that such tax policy would wreak on our schools, roads, parks and military. So, dismissing this extreme position leads us to accept the fact that taxes must be levied and a more relevant question might be the consideration of the factors that make for a sound tax policy.