How Behavioral Finance Can Help You Invest Wisely

A couple discusses financial decisions with their investment advisor

If you’ve ever bought or sold stocks, there’s a chance you may have done so based on feelings and emotions rather than cold, hard facts.

You might think you trade based on objective input while staying focused on your investment goals. But you’re human. You buy a stock because you saw a pundit talk about it on TV. You sell a stock because it’s lost some value, and you’re freaked out. You might have even bought or sold stocks simply because it feels good to make a money move.

Even if you haven’t traded based on your feelings, there may be other times where you didn’t make the best investment choice due to a lack of information.

Behavioral finance is a new field of study that looks at how and why this happens. It looks at psychology and emotion and seeks to explain why markets don’t always go up or down the way we might expect.

Anytime you make a decision based on personal experiences and preferences, even when it comes to money, you are displaying a cognitive bias.

Conventional or Traditional Finance

People have been studying business and finance for years. As a result, there are many theories and models that use objective data to predict how markets will respond under certain settings. The capital asset pricing model, efficient market hypothesis, and others have fairly good track records of predicting the markets. But these models assume some unlikely things about investors, such as:

  • They always have complete and true data to help them make choices. 
  • They can handle a certain amount of risk, and the risk they can handle doesn't change. ​
  • They will always seek to make the most money at the greatest value.​
  • They will always make the most rational choices.

As a result of these faulty assumptions, normal finance models don’t have a perfect track record. In fact, over time, scholars and finance experts began to notice some deviations from their forecasts that their models could not explain.

Strange Stuff

If investors are acting rationally, there are certain events that should not happen. But they do. For instance, there is some data that shows stocks will have greater returns on the last few days and the first few days of the month. There's also the fact that stocks have been known to show lower returns on Mondays.

There is no rational reason for these things to happen, but they can be explained by human behavior. Another event, the “January effect,” suggests that many stocks do better than normal during the first month of the year. There is no conventional model that predicts this, but studies show that stocks surge during the first of the year because people sold off stocks before the end of the year for tax reasons.

Looking for Explanations

Human psychology is complex. What's more, it’s hard to predict every odd move investors might make. Still, those who have studied behavioral finance have concluded that there are a number of thought processes that push us to make strange investment choices. Below are some possible ways to explain these choices.

Attention Bias

There is evidence that suggests people will invest in companies that are in the news, even if lesser-known companies offer the promise of better returns. More than a few people have bought stock in Apple or Amazon simply because we know all about them.

National Bias

An American is going to invest in U.S. companies, even if stocks in foreign firms offer better returns. ​

Underdiversification

There is an impulse for people to feel more comfortable holding a fairly small number of stocks in their portfolio, even if wider diversification would make them more money.​

Cockiness

People want to think they are good at what they do. They aren’t likely to change investment strategies because they truly think they know best when it comes to their money. In that same fashion, when things go well, they are likely to take credit for their financial prowess when it fact their good results come from outside factors or sheer luck.

How It Can Help You

If you want to become a better investor, you'll need to become less human when choosing where to put your money. That sounds harsh, but it will benefit you to take stock of your own biases and know where your faulty thinking has hurt you in the past.

You should be asking yourself tough questions such as, “Do I always think I am right?” or “Do I take credit for investment wins and blame outside factors for my losses?” Ask yourself, “Have I ever sold stock in anger, or bought a stock based on a simple gut feeling?”

First and foremost, you must ask yourself whether you have all of the data you need to make the right investment choices. It’s not easy to know everything about a stock before buying or selling. Still, a good bit of research will help ensure you’re investing based on logic and facts rather than your own biases or feelings.

Consider a Robo-Advisor

One of the latest trends in investing is the use of robo-advisors, in which a company manages your investments with very little human intervention. Money is instead managed through mathematical data and algorithms. Some major discount brokerages, including Vanguard, E-Trade, and Charles Schwab, have robo-advisor services. There are a number of newer companies, including Betterment and Personal Capital, that also offer this service.

The jury is still out on whether robo-advisors offer better returns than average. But in theory, using a robo-advisor will enhance your chances of making optimal and rational investing choices. As more investors turn to this automated approach, we may see finance models become more accurate as human behavior plays less of a role in how markets perform.