The economist Richard Thaler is famous for exploring the consequences that our behavior around money can have on our financial success. Thaler has been instrumental in the development of the relatively new study of behavioral finance. The concepts within behavioral finance contradict what has been assumed over the last few decades. Traditionally, economists viewed each person as a rational being making choices in pursuit of their own self interests.
Thaler was awarded the Nobel Peace Price in 2017 for his scholarship. Thaler and the field of behavioral finance claims that we are not as rational as we thought. The controversial assertion says that we have biases that pushes us to take less than optimal financial decisions. Even though, we all want the best for ourselves and our families, these biases might be stronger than our will to stay disciplined financially. Here’s a small list of the multiple biases we face. (For related reading, see: Who is Richard Thaler, Economics Nobel Prize Winner?)
We tend to overestimate our own skill and prediction for success. Many of us take on a lot of risk with confidence that our investments will continue to grow. However, we all know that good times don’t last forever. The markets always correct eventually, and many investors get hurt in the meantime from their overconfidence.
Regret Aversion Bias
Many investors also fall in the regret aversion trap when they see one of their investments losing money. They might only share about their winners and avoid talking about the bad investments they have made. Furthermore, some of us might even stay in our losing investment in the hopes to see it rebound eventually.
Additionally, some of us might be a victim of our herding behavior. By investing in what the crowd is putting their money, we can minimize our regret of making a bad investment choice if everybody else is losing money as well.
Loss Aversion Bias
Some studies have found that losses are psychologically twice as powerful as gains. Someone who is very loss averse would rather invest in a CD that pays 1% but is guaranteed not to lose than invest in a diversified portfolio because of possible losses. Even if that person knows that returns lower than the rate of inflation means that the value of his/her money is going down.
Save More Tomorrow Philosophy
Richard Thaler’s work is changing the world. Many retirement plans have adopted his Save More Tomorrow (SMART) design philosophy. By making small investment increase every year, someone is more apt to getting the investment process started. Under this new type of plan, employee participation and deferral rates are soaring.
A few years ago, the Department of Labor announced support for automatic retirement plan enrollment. An employee is now automatically enrolled in a company retirement plan and can opt out if so desired, contrary to having to opt-into the plan.
When you can stay focused on the financial plan you've crafted, you are closer to living the life you deserve. (For more, see: Behavioral Finance: Introduction.)
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