Traditional finance assumes we are logical. Perfectly rational, risk-averse, self-interested, utility maximizers. But are we really? Or do our experiences and prejudices shape the way we invest? Could our subconscious mind be causing us to make bad decisions? The relatively new field of behavioral finance explores these questions. We want to be sure we are maximizing our wealth so let’s find out what has been discovered so far.

Are we really risk averse?

Financial literature begins with the presupposition that investors are risk-averse. That means that given the choice between lower returns with known risks and higher return with unknown risks, the average investor will choose the known risks and lower returns.. While most of us agree we are risk-averse, millions of us still purchase lottery tickets. The odds of winning are very low and clearly uncertain, yet many risk-averse investors can’t help but think they have the golden ticket. Somehow the possibility of a large gain suddenly changes us from risk averse to risk loving!  Wait… What? But we don’t do that in our portfolios do we? Perhaps we do. Stocks hyped up by the media may also suddenly become very attractive when there is a possibility for large gains. We can set aside logic and reason for the possibility of a large pay-day. We must remember to examine whether or not the stock is a good fit for our portfolio regardless of media coverage and remember to ask ourselves if the risk is the right for us.

 

Are we rational, or do our minds play tricks on us?

Faulty cognitive reasoning can be thought of blind-spots in our minds. The good news about blind-spots is that they are relatively easy to change when we are made aware of them. Cognitive errors, also commonly known as cognitive dissonance, occur when we are given new information that does not fit with what we already believe to be true. To prevent this from happening, we may notice only information that matches what we already believe to be true or even modify information that conflicts with our beliefs. This may mean we are inaccurately incorporating new information into our portfolio decisions. We need to ask ourselves, are we under- or over-reacting to news about companies we are invested in? Do we have preconceived notions about what our stock will do and are we holding onto positions in our portfolio in spite of new facts to the contrary?

 

Are we really logical, or just emotional?

Because emotion arises spontaneously rather than through a conscious thought process, emotional biases are much harder to control and correct for. Some examples of emotional biases include holding onto losing investments because the idea of truly losing money is too painful. Or the case of overconfidence bias where someone may have unwarranted faith in their own reasoning resulting in excessive trading. Another example is self-control bias where someone fails to pursue long-term goals such as retirement savings because of a lack of self-discipline. There are many more emotional biases but the solution to all of them is awareness and a disciplined approach to investing. One where money is set aside with a plan, and investments are bought and sold with a blueprint set out in advance.

 

How to Nav.it

Being aware of how our minds play tricks on us is the first step in addressing our issues. We will never be perfect but hopefully we will be a bit more rational after reflecting on our attitudes and biases. Disciplined investing and a plan of action for our portfolio before we even begin to trade are essential to avoid brain games.