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Are You an Irrational Investor?

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When it comes to investing, even the most savvy of us fall prey to bias and emotional trades. So what triggers should you watch for?

Geopolitical events. Elections. Fear of Bubbles. Panics.

Any one of these is enough to keep the average investor on edge with an itchy buy/sell trigger finger. But a growing body of psychological and financial theories called "behavioral finance" is showing that during uncertain times, it’s more important than ever to rely on available data and put aside emotion-fueled investing.

This field of research which marries economics with biology and psychology studies certain types of investing decisions—including those made on emotional or speculative grounds, often made hastily without all the facts or because of what others are doing.

The lead-up to last fall’s presidential election is an example of investors feeling pressure to make decisions based on what might happen—in this case of course, which candidate they thought would win. As an example, some investors wondered if municipal bonds would still be an attractive holding under a Trump administration, given his proposed tax cuts. Others, anticipating a potential tax increase with a Clinton win, wondered if they should be buying more munis.

"Behavioral Finance is all about separating the irrational mind from the rational mind."                    

A Pattern of Behaviors

Behavioral finance theory identifies a number of behaviors that investors typically fall prey to.  Herding, or following the crowd, is the tendency to flock into the same sectors or markets that others are gravitating toward.

Another behavior is anchoring, where investors are slow to react to fundamental changes in economic, corporate or market developments because of an irrational attachment to a perceived value, even in the face of changing information.

Still another is called a recency bias, where investors believe that things that happened recently will continue. If the markets have been up, some investors project that forward, though there may be no fact-based data to back up that premise.

These types of behaviors explain why people tend to buy stocks after a long rally and sell after a long or sharp decline. Put in more general terms, behavioral finance is about separating the irrational mind from the rational mind. Unfortunately, as humanity is often irrational, the deck is typically stacked against us.

The Role of a Financial Advisor

Behavioral finance theory can be used to help investors develop a greater understanding of how their minds work and to show them that their investment decisions shouldn't be driven by emotion, but rather by a coherent strategy. The goal is not to make them smarter, but to make them aware of basic human psychological shortcomings so they are less likely to undertake counterproductive actions. Or—at the very least—not to make snap judgments every time there is a potential trigger incident.

A good way to combat these kinds of knee-jerk decisions is to slow down thinking and separate fact from fiction. Another tool is to rely on someone who can look at markets with clarity, such as a Financial Advisor.

This first step is to align investments with values and goals rather than hunches. Having a concrete roadmap for investments removes some of the emotion and more-easily reveals irrational biases.

Finally, it's worth mentioning that it's a mistake to assume that only novice investors can fall prey to poor decision making when it comes to investments. Even among sophisticated investors, once emotion takes hold, anyone can make irrational decisions. Biases affect everyone, because, in the end, we are all human.

 

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