Traditional finance is based on the premise that investors are able to consider all relevant information to make rational financial decisions. The underlying assumption is that all investors are risk averse and that everyone prefers higher returns to lower returns for the same level of risk. In practice, these assumptions are unrealistic because investors are not perfect and are subject to behavioral biases. Behavioral finance is a relatively new field of study that analyzes human behavior to explain why investors make irrational investment decisions and its effect on financial markets. By having a better understanding of how behavioral biases affect our investment decisions, we are more likely to make rational investment decisions that improve the efficiency of our portfolios and make us better able to stick with our investment plan during adverse conditions.
Behavioral biases can be divided into two categories: cognitive errors and emotional biases. Cognitive errors result from the inability to process information accurately. Whereas, emotional biases are related to feelings and impulses, which are usually more difficult for individuals to correct for than cognitive errors. Some of the most common behavioral biases are loss aversion, framing, mental accounting, and endowment.
Loss aversion is an emotional bias that occurs when investors feel more pain from selling an investment at a loss than selling an investment at an equal gain. This feeling causes losers (current investments at a loss) to be held too long in order to avoid the pain of realizing a loss in hopes of breaking even. At the same time, winners (current investments at a gain) are sold too quickly to lock-in profits and avoid potential losses. This behavioral bias can increase the risk of the portfolio while limiting expected returns. Similarly, the framing bias is a cognitive error that results from making buy/sell decisions based on whether an investment is perceived to be held at a gain or a loss. Putting tax considerations aside, a buy or sell decision should be made based on expected returns and risk.
Mental accounting is a cognitive error that comes into play when investors think of the underlying assets in the portfolio as separate investments. In other words, the interaction or correlation between the assets is ignored, as a result, too much emphasis is usually on income-generating assets (dividends). Instead, the focus should be on total return (dividends + price appreciation) that is needed to meet your long-term financial goals. Additionally, the endowment bias (emotional bias) can be observed when investors think their assets are worth more than they actually are simply because they own the asset or have held the asset for a long time. Getting too emotionally attached to your asset can keep you from selling it when it’s deemed the asset no longer provides a benefit to your portfolio.
Once you’re aware that you are subject to a behavioral bias, you can try to moderate the bias or adapt to the bias. Financial advisors can help you meet this objective by taking your personality type into consideration when creating an investment plan. This will result in more rational financial decisions than those that are assumed by traditional finance, which can improve the efficiency of your portfolio.