We wanted to shift gears from our emails about shareholder advocacy and instead talk about one of the more cloudy aspects of investments and finance: how we as humans make financial decisions. This topic is called behavioral finance and one that can have an outsized impact on financial success. To be realistic about our thought process with money, it’s important to realize that emotions, biases and assumptions incline us in certain directions. Money is not void of emotion, and neither are our money decisions.
An elegant example of this is called the behavior gap. It’s the phenomenon in which an individual investor’s returns tend to underperform the benchmark returns. Why could this be, isn’t investing as simple as putting money into investments, leaving it there for a long time, and achieving benchmark returns for that time period? For the average investor without an advisor, research shows that has proven challenging for a multitude of reasons.
The behavior gap phenomenon is the most visible part of the behavioral finance iceberg. What lies beneath are various mechanisms that can all play a part in producing it. We don’t want to emphasize that all aspects of behavioral finance show themselves on investment reports. They may show themselves just as strongly in the way you feel about your financial life before you go to bed. We think both are important and we hope this is good food for thought. Ultimately, we want to assist you in leading the best financial life, by the numbers and otherwise.
The list below are some primary mechanisms we have encountered, and a one sentence idea to improve them.
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The Emotional Rollercoaster: Emotions like fear and greed can cloud our judgment. During market volatility, fear may push people to sell low. During market exuberance, greed can lead to impulsive buying at high points or buying popular securities. The key is to maintain a rational, long-term perspective using your own financial circumstances as an anchor point.
Confirmation Bias: We tend to seek out information that confirms our existing beliefs, ignoring or discounting evidence to the contrary. This can lead to over (or under) emphasizing potential risks or dismissing valuable opportunities. To counter this, actively seek diverse opinions and data, AKA ask Blue Summit!
Loss Aversion: Studies show that people feel the pain of losses more acutely than the winning feeling of gains. This can lead to a reluctance to take risks, or remain indecisive, even when the rewards for taking action have good odds of success. Diversified investments that spread out risk, and potential loss, can help mitigate this mechanism.
Overestimating Short-term Impact, Underestimating Long-term Consequences: We often underestimate the long-term effects of our financial decisions. This can result in neglecting important aspects like the asset allocation of our 401k, or chasing a hot stock instead of bolstering your thin emergency savings. Imagine sailing across the Pacific, a few degrees shift in your heading can significantly change your destination. Focus on that instead of the day’s weather or sea state.
As your advisors, we hope to provide guidance that brings these mechanisms into balance and narrow the behavior gap. We also aim to offload many aspects of your financial life, allowing you to focus on other interests. Our goal is to empower you with the knowledge and support needed to navigate the complexities of financial decision-making. Making decisions about money isn’t easy – we're here to offer valuable perspective and context every step of the way.
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