Behavioral Finance and Risk Management
March 11, 2020
When it comes to financial planning, the word you hear more often than any other is “risk.” Calculating risk, managing risk, and deciding how much risk you’re willing to take on will drive your decisions when it comes to what to do with your money. Understanding behavioral finance and risk management will give you a better understanding of your own financial planning.
Unfortunately, we as human beings aren’t very good at evaluating risks, numbers, and statistics. Consider the fact that for nine straight years, active hedge fund managers have underperformed the S&P 500. Even the self-designated experts aren’t very good at assessing the risks of individual stocks.
That’s where the field of behavioral finance comes in — the study of how human psychology influences the behavior of consumers, investors, analysts, and financial advisors.
How Behavioral Finance Works
The traditional model of financial theory assumes that both the market and those who invest in it are perfectly rational. They’ll assess all the risks and potential benefits and take the route that’s the most reasonable. It also assumes that investors have perfect self-control, uninfluenced by personal biases or mistakes. But behavioral finance and risk management don’t always fit this model.
In reality, people aren’t perfect. Both investors like you and financial advisors like us are subject to personal biases, cognitive errors, and blind spots in judgment. No one has perfect self-control, no one is perfectly rational, and no one is completely immune to making mistakes. That’s why, especially when it comes to behavioral finance and risk management, financial advisors do their best to take every factor into consideration before making suggestions.
Examples of Decision-Making Errors
Behavioral finance theory tries to take this all into account. Investors are treated as “normal,” not perfectly rational. No one likes to hear that they’re behaving irrationally, but the fact is that we all make gut decisions sometimes. There are several powerful cognitive biases that come into play when we’re making decisions, financial or otherwise:
- Overconfidence: the belief that we’re better than we are. We have a tendency to assume that we’re more intelligent, more astute, or more in control than we actually are, and it affects our decisions. In one survey, 74 percent of fund managers thought they were “better than average” at investing. The other 26 percent thought they were average. Obviously, this is impossible.
- Self-Attribution Bias: a tendency to attribute good things, like an increase in investment value, to our own positive decision making, while attributing negative events to simple bad luck. When 401k investors panicked during the 2008 recession and saw huge losses, they blamed the market — not the fact that they decided to sell low.
- Hindsight Bias: the belief that we “always knew” something would go the way it did, leading us to believe that we had some special ability to predict or control the outcome. Look at the 2008 crash again. People love to say that all the predictors of a bursting bubble were obvious, but the fact remains that almost nobody saw them — and those who did got laughed at.
- Framing Bias: the tendency to make decisions based on how the information is presented, rather than the facts themselves. Saying that a given stock has risen 5 percent in the last six months sounds a lot better than saying that the stock has fallen 15 percent in the last two years, even if both are true.
- Loss Aversion: we tend to fear loss more than we value rewards. Some investors become so focused on mitigating risk that they ignore opportunities to net significant gains. In one study, researchers asked participants if they would take a bet based on a coin flip. If the coin came up tails, they’d lose $10. The question was, how much would they have to gain if the coin came up heads to make the bet? As it turns out, people generally demanded at least $20 before they thought the coin toss was worth the risk.
- Herd Mentality: thousands of people can’t be wrong, right? Herd mentality is the tendency of people to follow the crowd — assuming there must be something to a strategy if everyone’s doing it, rather than following the objective analysis. The fact is, just because something is popular doesn’t mean it’s a good idea. The bitcoin bubble is a classic example. Bitcoin isn’t anchored to any fiat currency or to a finite resource like gold, and it can’t be spent in very many places — its entire value is based on what other people are willing to pay for it. As a result, Bitcoin grew 2700 percent in 2017, then crashed by 65 percent in less than a month.
How to Overcome Behavioral Finance Biases
To overcome the behavioral finance biases that inform poor decisions, there are lots of strategies that we as advisors can use to steer our investors in the right direction. First things first: stay focused on the process. While it’s our default option to go with our guts when making a decision, it’s a much better idea to take time to reflect.
Next, take the time to prepare, plan, and pre-commit to the plans that make the most sense for you. If you don’t, you’ll leave yourself open to impulsive behavior that can sink all the carefully made plans you’ve laid out.
A Holistic Approach to Finance
At First Western Trust Bank, we know that simple accumulation of wealth is not the end game — it’s the means to accomplishing your other goals. You might want to invest in new businesses or industries that you find promising. You might want to support charities or non-profits that are making a positive contribution to the world. Or you might want to leave a lasting legacy for yourself and your family.
Regardless of your long term goals, your personal financial situation will be about more than just the bottom line of your balance sheet. Our proprietary ConnectView system examines every aspect of your financial, experiential, relational, and legacy wealth.
We believe that every person’s financial situation is unique and deserves a customized, personally tailored plan, and we work hard to forge the personal relationships with our clients that allow us to deliver the solutions that are right for you. If you’re ready to make a commitment to your financial planning, get in touch! Our team of experts works across a variety of financial disciplines to help you reach your goals.