Beau Browning, ChCF | May 27, 2020
We humans are not the most rational creatures when it comes to many areas of our lives and our finances are one of them. We make decisions based on emotions and that can be a dangerous thing, particularly when it comes to money and investing.
Behavioral finance is the study of the psychology and biases behind financial decisions.
There are four key concepts in behavioral finance:
Herd Behavior: The habit we have of following the financial behaviors of the majority around us.
Mental Accounting: The propensity we have to allocate money for specific purposes.
Anchoring: Relying too heavily on pre-existing information or the first piece of information
we find when making a decision.
High Self-Rating: Our tendency to rank ourselves higher than the average person.
Herd behavior is something we’ve seen a lot in recent months. Millions of people felt a lot of fear and uncertainty about COVID-19 and started selling off their stocks based on those emotions. The mass self offs sent the market plunging. Selling when everyone else is selling results in the exact opposite strategy for successful investing, buy low, and sell high.
An example of mental accounting is how we treat “money we can afford to lose.” We know we can’t afford to lose our retirement money so we’re careful with it. But we tend to play fast and loose with some “other kinds” of money, particularly “found” money like bonuses and tax refunds. Rationally we should treat all money the same, but again, humans aren’t rational!
An example of anchoring would be shopping for a new pair of jeans. The first pair you see cost $300 and then you find a pair for $150. The second pair seems like a bargain even though you can find jeans much cheaper than $150. The price of the first pair unduly impacted your opinion on the price of jeans.
High self-rating is simply overconfidence. This is an asset in a lot of areas of life but not when it comes to investing! It can lead us to believe that we have special abilities that allow us to spot the next hot stock or investing trend and get in on it before the herd behavior people get on board. Those who exhibit this behavior often trade frequently which results in a sub-par portfolio performance due to the increased commission, taxes, and losses when compared to those who take a more buy and hold approach to investing.
Awareness is Your Weapon
There is data to support the notion that investor behavior is actually the biggest factor in poor long-term investment returns.
Emotion causes us to react and make a decision in the heat of the moment without considering the long-term ramifications of acting this way.
Simply being aware of the four major concepts of behavioral finance can help us recognize those behaviors in ourselves. We might not recognize we’re exhibiting one of these behaviors immediately but when we know what they are, that might be enough to stop us in our tracks and protect us from our worst enemies, ourselves!
Your Advisor is Your Secret Weapon
Knowing is half the battle, yes but sometimes it’s just not enough. Psychological influence is a powerful thing and no matter how smart we are, no matter how much good, common sense we have, sometimes we just can’t help ourselves! Because none of us thinks we’re wrong, even when in the back of our minds, we know we are.
That’s where your CoreVision team comes in. An advisor provides a lot of value and that value has been quantified:
Earning our Fee
Many investors view the fee they pay a financial advisor as an out of pocket expense. The truth is the value that a good investor brings should more than offset their advisory fee. Vanguard has estimated that the value added by a competent financial advisor is roughly 3% per year (net). So, what do we do to earn your fee?
|Value Added for Client
|Customized asset allocation
|Cost effective investment selection and monitoring
|Annual tax harvesting
|Ongoing consultations on your financial/retirement plan
|Tax-efficient retirement income strategy
|Asset location planning
|Liaison with your other financial professionals
|Total Value Provided:
|225 bps or 2.25%
As you can see, behavioral mistakes have the greatest impact by a wide margin.
Your financial plan isn’t about returns, it’s about goals. Your plan is based on your goals and adhering to the plan, no matter what psychological biases are telling you to do is how you pursue those goals.
If you’re having a hard time sticking to the plan, for whatever reason, reach out. We’re here for you.
The opinions voiced in this letter are for general information only and are not intended to provide specific advice or recommendations for any individual.