Articles

Behavioral Finance and the Impulsive Investor

By : Ginger Weber | August 20, 2011

It is not uncommon to see investors making irrational financial decisions. Behavioral Finance is a relatively new field that combines psychology with conventional economics to determine why these decisions are made.

Ginger Weber is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

Behavioral finance is something that any skilled investor should consider. “Availability Bias” speaks to the fact that people tend to heavily weigh their decisions toward the latest news. Early this year, investors were being bombarded with a constant stream of negative headlines from the financial media.

Amid the following stream of depressing captions, investors pulled billions out of the stock market:

  • “Financial Crisis, War & the Rise of National Socialism in America”
  • “Trend Alert: U.S. Has Entered ‘The Greatest Depression’

According to the Investment Company Institute, a national association which compiles data related to mutual funds, investors redeemed over $52 billion from stock mutual funds in February and March 2009 alone. Many of these assets ended up in taxable and tax-free bond funds.

Unfortunately for those investors, the stock market has rallied over 50% from its March lows while bond funds have produced relatively low to negative returns over the same period. Investors influenced by and reacting to the enormously downbeat and highly available stream of information relating to the financial crisis have missed out on one of the most significant rallies in recent history.

“Recency Bias” refers to the tendency to remember recent events or observations more vividly and to give recent information more weight than historical information. During the heat of the market decline earlier this year, it was very difficult for many investors to keep a historical context of market behavior in mind. Stories of how different this environment was from past bear markets were rampant, and many individuals abandoned their stock positions, favoring “safer” alternatives.

OUR PRESENTATION

Ginger Weber is a CFP, Certified Financial Planner and a 401(k) Financial Advisor with Premier Financial Group in Eureka Humboldt County

On March 17, just one week after the market bottomed, our firm gave a presentation where we encouraged investors to set aside their emotions (easier said than done) and look at the current environment in a historical context.

We made the following points:

  1. When the stock market gets cheap, future returns tend to be favorable and
  2. When investors are highly pessimistic, future returns tend to be favorable

At the presentation, we also discussed the relationship between investor sentiment and future market returns. The American Association of Individual Investors (AAII) has shown that when survey participants are highly optimistic about the future, that might indicate a high point, or a market top, whereas highly negative sentiment generally coincides with a bottom or a good entry point for stocks. Such was the case here.

Investors often follow their gut with regard to their portfolios. Examples such as these indicate that this is not the best approach for accumulating wealth in the long run.

Takeaways: Your Next Steps

We know how challenging it is to be an investor. Information overload, volatile markets, stories of deceitful advisors make it hard to maintain quality investment programs for the long run. To minimize the negative impact that behavioral biases can have on your investment success, we recommend the following:

  1. Create Awareness: Think about your experience as an investor. Have you bought at the wrong time, sold at the wrong time, or made other subpar financial decisions? Think about how recency biases may have contributed to those decisions and commit to limiting their influence in the future.
  2. Eliminate the Source: Ignore or limit your exposure to the financial media. Media conglomerates know that buzz, hype, and playing on our fears sells, and they do this well. In addition to providing poor investment advice, the media serves as a detriment to one’s financial peace of mind.
  3. Reach Out: Find a trusted advisor who is legally required to put your interests first and who will be objective in their delivery of financial advice.

Feel free to call us for a consultation about your financial planning or investments. Consultations are complimentary and we can go into as much (or as little) detail as you like. 

Let's create a road map to your financial future

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