What is behavioral finance

Quantitative investing: invisible layers surface to deliver attractive returns. Related insights more insights. Low Volatility defies the basic finance principles of risk and reward. Contrary to popular belief, riskier investments do not necessarily translate into higher returns. Herding refers to when investors buy or sell shares in a company or sector because many other investors have already done so. Explanations for investors following a herd instinct include social conformity, the desire not to act differently from others.

Following a herd instinct may also be due to individual investors lacking the confidence to make their own judgements, believing that a large group of other investors cannot be wrong.

If many investors follow a herd instinct to buy shares in a certain sector. This can result in significant price rises for shares in that sector and lead to a stock market bubble. Studies have shown that there are traders in stock markets who do not base their decisions on fundamental analysis of company performance and prospects. They are known as noise traders.

Characteristics associated with noise traders include making poorly timed decisions and following trends. You can't beat the market, in other words, because anything you know already has or soon will be reflected in market prices. Starting in the s, its founders — including psychologists Daniel Kahneman and Amos Tversky, and economist Robert J.

Shiller — gained attention by conducting a series of artful experiments showing participants making misguided, emotional decisions. They would sometimes keep doing so, even after they were told why their choices weren't the optimal ones.

What the behavioral finance researchers quickly found was that investors frequently failed to act rationally and that the markets were full of inefficiencies due to investors' flawed thinking about prices and risk. As Shiller wrote in an influential paper , "we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information. Behavioral finance acknowledges that investors have limits to their self-control and are influenced by their emotions, assumptions, and perceptions.

These biased and irrational behaviors have real costs. They help account for the difference between what investors should be earning and what they actually manage to take home.

DALBAR, a financial research firm, has conducted many studies comparing investors' rate of return against the performance of the market.

For instance, the average investor in equities earned an average annual return of 4. Fixed-income investors also left money on the table, earning 0. At the same time that a common index fund of bonds, the Bloomberg Barclays U. But they did worse.

There is a multitude of self-defeating or counterproductive behaviors that bring human beings down. Behavioral finance experts refer to them as "biases.

Anchoring is our tendency to estimate worth or value based on whatever numbers we have access to. For instance, people with a lot of money who mainly associate with other high-net-worth individuals are likely to overestimate the cost of everyday things.

What could it cost, ten dollars? Somewhat oddly, anchoring occurs even with numbers that have nothing to do with each other. In one often-duplicated class experiment, a teacher conducts an auction of random household items.

Every student is asked to write down their social security number's last two digits and then their maximum bid for each item. Students with the highest social security numbers tend to bid higher than those with lower sequences.

Those irrelevant social security numbers helped anchor students' idea of a fair auction price, even though there's obviously no connection between the two. In investing, anchoring comes into play with the use of irrelevant or no-longer relevant information to evaluate an asset or a financial instrument — a psychological benchmark that influences you too much. The disposition effect in a nutshell explains why even experienced investors mistime their investment moves. If a stock's going up, we get anxious and tend to lock in the value too quickly by selling.

At the same time, we are too slow to cut our losses on dogs, keeping our losers in hopes that they'll turn the corner.

But usually, they don't, and we lose even more. Money is fungible — that is, interchangeable; all funds are the same, regardless of where they come from or are used for. Yet, in a variety of ways we treat some kinds of money differently — assigning it different values or classifications. This is called mental accounting, a term coined by the behavioral economist Richard H.

According to Thayer , "Putting labels on money has a long history and serves a purpose. For example: treating an IRS refund as a windfall. It's not — it's your own money coming back to you. Or refusing to touch a legacy —" it's money my dad left me" — when you're deep in debt. Or maintaining a low-paying savings account "because it's for the kids' college," instead of investing in something still relatively safe, but with a better return.

You've probably heard of herd mentality — a tendency to follow and copy what others are doing. In the behavioral finance context, it refers to mimicking what other investors or the market overall is doing, without a rhyme or reason of your own.

Throughout financial history, herd behavior has been behind many a speculative frenzy in the stock market, like the dotcom bubble of the late s — and the cause of many stock market crashes and panics. Just about everyone offers a plan, a portfolio, and access to a human advisor, for some price.

That price can differ drastically from full-service advisors to highly-scaled virtual advisory services that charge next to nothing. Then I look at what makes them different, and they talk about a plan, a process, and caring about their client. That is what every advisor offers and says.

Those that ignore that truth may miss the opportunity to progress and increase their value. Those that face it head on and do something about it may be able to improve their game, and ultimately their business. Do you actually offer something different? I would say that effective application of behavioral finance is different, but you still have a challenge. And how do you frame such to a client or prospect? How do you ensure that the client perceives whatever you offer as different and superior to your competition?

This is where proper framing, and the psychology of communication come in. And it all starts with your value headline. You need to figure out what you want to highlight, and make it pithy and personal to you. This is not an easy exercise. I work with advisors to come up with unique headlines that represent what they most want to say. This is often done through strategy calls, brainstorming sessions and back and forth emails. But with each one, we eventually find it. And then we build on it, ensuring that we frame every message in a way that supports the value headline and adds the personality of the advisor — because you are what is unique.

You are what the client is buying. Two calls and several emails resulted in lots of ideas, but nothing that really clicked. At that point it hit me — his passion came out.

For me, it was a no brainer because I finally saw him for who he is and how he wants to be portrayed. This was funny and it was very true. It captured the essence of who this advisor is, and he got excellent feedback from clients and others in the industry.

A great value headline is one that shows your prospects, in less than two seconds, who you are and what you will do for them in a unique and compelling way. Behavioral finance in applied practice with clients is somewhat ambiguous. There is no one book or formula on how to apply behavioral finance. Academia and many white papers encourage advisors to learn the biases, identify the biases, and then educate the client. Empirical evidence, and perhaps your own experience, tells us these are not effective.

The effectiveness of behavioral finance application can only be judged by your clients. Does it engage them, and do they reply to the messages? Do they find value in the messages? Do they share the messages with others? Does it improve both investor behavior and experience? Application of behavioral finance is something new, and may require trial and error to figure out what works best for you and your practice.

There are a few ideas outlined in this article to help you, but they are by no means inclusive. I have learned through many years that there are people that cannot be helped. In most cases, those clients need to be fired.

Still, for many investors, behavioral coaching can help move the needle along the continuum of emotions and rationality.

Give each client the best odds at reaching their goals, despite any biases they may have. General Inquiries: Questions Kitces. Members Assistance: Members Kitces. This browser is no longer supported by Microsoft and may have performance, security, or missing functionality issues. For the best experience using Kitces. Practice management advice and tools relevant for your business. Join 47, fellow financial advicers getting our latest research as it's released, and receive a free copy of The Kitces Report on "Quantifying the Value of Financial Planning Advice"!

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