Behavioral Finance – Part 1

Behavioral finance examines the psychological aspects about how we make decisions about money. This is part one where we will examine two theories of behavioral finance and how it effects our financial decisions.

Hopefully, you'll have a better understanding of which and how these theories apply to you. The first is “loss aversion.”

Ever buy a stock that plummets with little potential of recovery? It becomes very hard for you to sell and take a loss. Over the years, it sits on your statement and sometimes even loses more value.

Does this scenario sound familiar? If so, you're not alone. The pain of losing money is much harder to deal with than the pleasure of making money. Psychologists say taking losses is twice as hard as taking gains. It's the admission that whatever we initially bought was a mistake in the first place.

For some of us, loss aversion leads us to buy only guaranteed investments like CDs or U.S. Treasury bonds. Obviously, these rates are low and if the rates allow you to reach your goals, then there is nothing to worry about. It's only when you need to take risk to grow your portfolio for a goal such as retirement where you have to be somewhat tolerant to see losses on your statement. Even if you have a diversified portfolio, there will always be some losers - it's just part of investing.

When meeting with your financial planner about a maximum downside you are willing to assume, use dollar figures rather than percentages. Be prepared to take losses if it's the right decision for you in the long run.

The second behavioral finance theory is “regret aversion.”

Do you ever avoid making a decision, because you think that whatever you decide, you will be wrong, and regret it? Or have you ever put your money in a CD because you feel that if you invested it, you would make a "sub-optimal choice?"

Don't worry! Once again, you're not alone! This is called regret aversion.

Many investors steer clear of taking important actions with their investment portfolio, because they are afraid, that in hindsight, they will make the wrong decision.

At times, the inability to make decisive financial decisions, can cause you to be too conservative with your portfolio. When this happens, expected rates of return go down. After inflation and taxes, your real return may not be that great.

So what can you do?

• Be patient. Expect that many of your decisions may be wrong in the short term, but as your investment time horizon increases, the odds of you being right go up.

• Diversify. It's easier to make decisions when you aren't putting all your eggs in one basket.

• Doing Nothing Is A Decision. Understand that doing nothing and leaving everything in a CD or money market fund is in fact a decision.

• Partner with a trusted adviser. Have your financial planner act as a sounding board when you are faced with difficult decisions.

(This article is for informational purposes only and should not be construed as individualized investment advice.)