San Francisco Financial Planner, San Francisco Financial Advisor

Video Summary: Behavioral Finance explores the way investors make decisions. Economists presume we are rational human beings, coldly weighing the pros and cons of our decisions. We have “loss aversion” which means that losses hurt us more than gains provide us pleasure. All of these are at odds with the classic economic view that investors behave rationally and unemotionally. The reality is that we don’t behave that way, we have bias’ and emotional attachments. Here are three psychological tendencies that, if you can avoid, will probably lead to better investment decisions.

Anchoring – The idea that investors put too much emphasis on irrelevant data. An example is the break-even fallacy. Often investors realize they have made a mistake... by purchasing a particular security when it has fallen in price. They say to themselves; “When it goes back up to the price that I paid, then I will sell it.” The price you paid originally is irrelevant. The “market” does not know (nor care) what price that you paid for the security. The only relevance is that it represents the price at which you will measure your gain or loss. What is most relevant to your purchase or sale decision should be -- “Is the underlying business worth less than my original assessment enough to warrant a sale.”

Recency Bias – This is the concept that investors tend to overweight the most recent information about a security rather than looking at the “big picture”. Evidence can be found in analysts’ consensus estimates for future earnings. As the economy expands and earnings tend to rise quarter after quarter, analysts extrapolate these positive developments by further increasing their estimates. Not surprisingly, when the economy goes into recession and the news (and earnings) grows increasingly negative, analysts tend to revise their estimates downward even while the economy starts to improve. On Wall Street, nothing lasts forever and it is better to consider the full body of data equally. Rather, most investors place too much emphasis on headlines and recent events.

Availability Bias – Investors tend to overweight the importance of data that is more readily available. An example is the headlines you read or the lead stories on financial television. Regardless of whether it is right, wrong or irrelevant…they impact investor behavior. Most investors do not read the 10K reports provided by public companies on a quarterly basis. But there is likely more important information buried in that disclosure or the footnotes that is important to your investment decision. You also find that investors have a “home country bias”; they tend to feel more comfortable and invest more in their own country. Why? Because they are more familiar with local companies and their personal experience and data is more readily available.