Curb Your Emotions – Behavioral Finance
February 24, 2015
Investing requires long term rational thought. Investment professionals – such as the famous Warren Buffet – are often quoted as saying phrases such as “emotions have no place in investing” or “the stock doesn’t know you own it.” The effect of emotional investing is usually negative and is driven by fear, greed or paralysis caused by over analysis. At Clay Northam Wealth Management we recognize that the ideal conditions noted above are really never the case as personality and previous experiences always influence an investor’s decision. The psychology behind how investment decisions are made is a recent field of study called behavioral finance. Traditional investment theory assumes that decisions are based on rational, even mathematical expectations. Behavioral finance points out examples of thought processes that lead to irrational financial decisions.
These processes include such things as “Anchoring” where a given reference point such as a previous high stock price is relied on by people deciding whether to buy even though the anchor price may itself not be a relevant number. Another process is “Mental Accounting” where people hold their assets in different mental jars such as one for vacations, one for education, and one for the rent with different risk requirements for each rather than treating it as one uniform portfolio. An especially interesting one has been labeled “Gamblers Fallacy.” An example of gamblers fallacy in investing is assuming a stock’s price will not continue to increase tomorrow because it has already increased every day this week even though the probability that it will increase tomorrow is not related to the previous days’ increases. Another is “Loss Aversion ” which indicates that people have a greater aversion to the pain of loss than to the pleasure of winning.
At Clay Northam Wealth Management we integrate the psychology of making investment decisions with traditional investment tools and techniques. We recognize that behavioral biases exist and work to manage them. There are many benefits to be gained from combining traditional investment solutions with psychological knowledge. The main way we do this is by setting goals with each client based on the client’s eventual use for these funds. A risk profile is then developed via discussions to determine the client’s overall risk tolerance. We address behavioral biases such as overconfidence which causes investors to take risks that don’t offer commensurate returns or overreaction to a random event which causes investors to avoid the market after a downturn.
Once goals are established we then work with the client to determine strategies to meet these goals that incorporate the individual’s risk tolerance. Different goals may have different strategies. For example a client may want part of the portfolio to be at very low risk to build a dependable base and part of it to be available for superior growth. Measuring the results and revisiting the goals, strategies, and selected investments is an important step in keeping the portfolio on track.
We are happy to work with our clients to help them attain their goals. Please contact us whenever we can help.