Behavioral finance is a relatively new field of study that is starting to gain popularity amongst both the mainstream and economists and finance experts. Behavioral finance theories seek to provide explanations about ways that human behavior and psyche can influence financial decision making. Understanding behavioral finance can give you a leg up when it comes to managing your finances and investing.
Traditional Theories Versus Behavioral Finance
For a long time, empirical evidence suggested that the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis (EMH) did a pretty good job of predicting and explaining how certain events impact markets. However, as time went on, academics started to find particular behaviors and discrepancies in these traditional theories that had no explanation. What they ultimately discovered is that these theories can only explain events where it is assumed that people (investors) behave rationally and logically. (For related reading, see: Effects of Behavioral Biases in Investing Decisions.)
Emotions and Money
The reality, though, is that the real world is actually a very messy place where market participants frequently behave irrationally. Contemplate for a second the emotional relationship you have with your money and some of the irrational decisions you’ve made in the past as a result. Ever bought a lottery ticket? Your odds of winning the Powerball lottery grand prize fall roughly in the ballpark of roughly one in 292 million. That translates to approximately a 0.0000000003424% chance of winning. With those odds, you might as well pull every dollar bill you’d spend on a lottery ticket out of your pocket and light it on fire. It is an irrational decision to buy a lottery ticket, but you do so anyway because of the emotional excitement you feel at the thought of winning it big no matter the odds.
Another great example of irrational behavior with money is what we saw in the Great Recession that began in December 2007 and ended in June 2009. On March 6, 2009, the Dow Jones Industrial Average (DJIA) hit a record-breaking low of 6,443.27, having lost over 54% of its value since October 9, 2007 high of 14,164.53.
When the Dow hit its all-time low, a lot of people had already lost entire fortunes. They made the single biggest mistake you can make investing - buying high and selling low. Logic would dictate that it is irrational to buy something at a high price and sell it at a low price because you lose money. Nobody would disagree with that, yet millions of people still did so. Watching their fortunes slip away on paper stirred up a tremendous amount of fear and anxiety, their emotions got the best of them, and they liquidated their portfolios to try to cut their losses. (For more, see: 4 Behavioral Biases and How to Avoid Them.)
In reality, though, they just lost a whole bunch of money, far more than they would have had they not sold and remained invested instead. Those that remained invested and went on a buying spree in the down market fared far better than anyone else simply because they took advantage of an opportunity to buy low and sell high.
It's amazing how the markets can fluctuate so wildly based purely on emotion and an abundance of sensationalist media. We’ve seen it happen time and time again despite what the fundamentals of the market may be telling us. These types of phenomena are what behavioral finance aims to explain.
Avoiding Irrational Decisions
As financial advisors, we live and breathe behavioral finance whether we realize it or not. Advisors attempt to understand what emotional factors drive their clients’ decision-making process and then use that information to help avoid irrational decisions when emotional responses take over.
Investors should use what behavioral finance teaches to their advantage. This timeless Warren Buffett quote sums it up pretty well: “Be fearful when others are greedy and greedy when others are fearful.” (For more, see: Logic: The Antidote to Emotional Investing.)